For traders active in the energy sector, crude oil and natural gas tends 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. (Related: Natural Gas Industry: An Investment Guide)
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. (Graphs courtesy of stockcharts.com)
The above graphs show that from November 2014 to March 2015, Brent crude oil and natural gas prices both fell dramatically. This seems to indicate a high level of dependency and similar price movement for the two commodities.
However, expanding the study period changes the picture completely. Between January 2013 and July 2014, Brent crude oil prices have remained stable in the range of $100-$115 (or around 15 percent volatility). Natural gas prices have varied much more widely from lows of $3.10 to intermediate highs of $6.25 (or effectively 100 percent volatility) and then back to $3.75 by the end of July 2014.
Similarly, a clear uptrend is visible in the natural gas prices from March 2012 to December 2012 (around a 60 percent increase), while crude oil prices have dipped in the initial period and then remained stable (regained the same levels). Effectively, there was no clear correlation to natural gas and oil prices.
From the above observations, there seems to be little correlation between crude oil and natural gas prices, but 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 energy products. The following graph is constructed based on the quarterly data and shows correlation between natural gas and Brent crude oil price changes.
Correlation–Understanding the Numbers
In the simplest terms, 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 change in oil price can account for 25 percent of the change in natural gas prices (on an average, over the period of study). Correlation is not a cause-and-effect indicator, rather it simply 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 graph:
- Over the last one decade (from Q1 of 2003 to Q3 of 2014), the average correlation between oil and gas prices was 26.53 percent.
- Although correlation remains mainly positive from 2003 to 2014, it does turn negative in the third quarter of 2010 when the price of crude oil and natural gas moved in different directions with large magnitudes.
- In addition, the positive values of correlation over other time periods are also of smaller magnitude, yet high variations. In other words, during quarters when correlation was positive, it was of small value. It indicates that gas and oil prices may not have any clear relation, even if small value positive correlation is visible.
Such varying values of correlation indicate that the gas price movement patterns may get reflected in oil price movements only to a limited extent. However, a striking deviation is visible as an outlier to the above inconclusive observation. During the periods of high oil prices (in 2005 and 2008), the correlation coefficient jumps from 26.53 percent to between 60 and 70 percent.
A possible justification for this pattern is that oil and natural gas are close substitutes for each other. Advances in technology now allow end consumers to 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 automobile). If the price of one energy source rises significantly, consumers move to other source of energy. This increases demand for the second energy source and its prices then also rise. This could explain why a follow-up pattern or a cause-and-effect pattern between high oil and natural gas prices has emerged only in cases of very high oil prices.
Observations 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 main reason for this is tha oil is a global commodity whose markets are well established with high volume trading happening all across the globe. In contrast, natural gas remains confined to regional pockets.
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 an inclination towards oil, the true relationship between oil and gas remains inconclusive, with indications tending towards oil being the driving factor.
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. During certain market conditions, like peak oil prices, natural gas prices have risen as well. The natural gas market, in the form of liquid natural gas is expected to grow dramatically in coming years, which will perhaps result in gas becoming a global energy commodity. As of today, the two fuels are close substitutes for each other in regions where both are supported by technology, infrastructure, and markets. At the global level, oil continues to be the king with observations indicating that natural gas prices sometimes follow with a time lag.