For traders active in the energy sector, crude oil and natural gas tend to hold the most interest. A continuous debate follows about how oil and natural gas prices are linked and to what extent. This article explores the relationship between crude oil and natural gas prices.
In the Spring of 2020, oil prices collapsed amid the COVID-19 pandemic and economic slowdown. OPEC and its allies agreed to historic production cuts to stabilize prices, but they dropped to 18-year lows.
Let's start with the historical price observations for both assets to set the context. Below are two graphs charting the prices of Brent crude oil (a type of oil that provides a benchmark for world oil prices) and natural gas, respectively, for the last three years.
- Chart comparisons of crude oil and natural gas over the past three years show minimal correlation.
- EIA data shows a strong correlation between crude oil and natural gas between 2003 and 2008, but little correlation between 2009 and 2019.
- Increased shale production in the United States provides a possible explanation for the delinking of crude oil and natural gas prices because natural gas is a regionalized product.
- Stronger periods of correlation could arise between the two commodities because oil and natural gas are close substitutes for each other.
Crude Oil Chart
Natural Gas Chart
The above charts show that both commodities tracked primarily sideways to lower for the first six months of 2017. However, between June that year and May 2018, the price of crude oil trended higher, while natural gas prices stayed relatively flat. Both assets declined sharply in the fourth quarter of 2018, although the sell-off in crude oil started in early October, whereas natural gas prices didn't start falling until December. Prices began to diverge again in 2019, with oil prices recovering between January and April, while natural gas continued trending lower. Since June 2019, crude oil traded sideways, whereas natural gas prices moved marginally higher.
From the above observations, there seems to be little correlation between crude oil and natural gas prices over the broader three-year period. However, a look at other data sources may offer a different view. The U.S. Energy Information Administration (EIA) provides historical data for a correlation study between crude oil other commodities. The following table is constructed based on the quarterly data and shows the correlation between natural gas and Brent crude oil price changes.
Correlation: Understanding the Numbers
In the simplest terms, the correlation between two asset prices is the extent to which price movement in one asset shows similarity with that of price movement in the other asset. A correlation coefficient between crude oil and natural gas of 0.25 indicates that a change in oil price can account for 25% of the change in natural gas prices (on average, throughout the study period). Correlation is not a cause-and-effect indicator; rather, it merely indicates how much similarity (rise and fall together) exists between the price patterns of the two assets. We can observe the following information from the above table:
From 2003 and 2008, there was an evident positive correlation between the two commodities—ranging from 0.25 to > 0.65. The positive relationship peaked in the second quarter (Q2) of 2004 and the Q2 and Q3 of 2005 while showing a relatively strong connection throughout each quarter of 2008. However, the data shows very little correlation between 2009 and 2019, apart from irregular quarters.
Fundamentals Behind Changing Correlation
Revolutionary hydraulic fracturing and horizontal drilling technologies that have significantly increased shale production in the United States provides a possible explanation for the delinking of crude oil and natural gas prices over the past decade. Because natural gas is a regional product, and oil is a global commodity, increased domestic production has driven down the commodity's price relative to oil's price.
However, stronger periods of correlation could arise again because oil and natural gas are close substitutes for each other. End consumers can now switch between fuels. For instance, a business could use a power plant that can switch between oil and natural gas, or a consumer could use a dual-powered vehicle. If the price of one energy source rises significantly, consumers have the choice to use another. This increases demand for the second energy source, and its price then rises.
Observations above, such as in Dec. 2018, suggest that oil has been the dominating factor in any observed relationship between the price of crude oil and natural gas (in other words, oil prices have a higher tendency to affect natural gas prices rather than the vice versa).
The Bottom Line
Based on the price patterns observed over the last decade, it is difficult to make definite conclusions about the correlation between crude oil and natural gas prices. The United States is one of the very few countries which appears to have a balanced infrastructure and established market for both oil and natural gas. However, as the rest of the world markets have a greater reliance on oil, the true relationship between oil and gas remains inconclusive, with indications tending towards oil being the driving factor.