1

International Market Integration for Natural Gas?A Co-integration Analysis of Gas Prices in Europe, North

America, and Japan

Guillaume L'Hégaret, Boriss Siliverstovs

Christian von Hirschhausen, Anne Neumann

DIW Berlin

6th IAEE European Conference

Zurich, September 2004

2

Agenda

1. The Issue: Internationalization of Natural Gas Markets

2. Theory and Data

3. Model 1: Cointegration of International Gas Prices

4. Model 2: Convergence of Trans-Atlantic Gas Prices

5. Conclusions

3

1. The Issue:Increasing Integration of Natural Gas Markets

- At the European level:

- EU-Acceleration Directive 2003/55: increasing competition within and between countries

- Decreasing weight of oil price indexation, e.g. long-term gas contracts in the UK

- At the international level:

- Trend towards LNG in the three large gas consuming regions (North America, Europe, Asia)

- Internationalization of LNG markets, in particular:

- Intensification of transatlantic LNG-trade and ... competition

=> This presentation analyzes the relation between international marker prices for gas and oil, with a view of quantifying long-term links between them

=> Our working hypothesis is that the split between the European and the North American gas markets did prevail in the 1990s, but that one might increasingly see signs of market integration

4

Net Inter-Regional Natural Gas Trade Flow, 2000(bcm, source: IEA, 2002)

6.7

1.7

1.7

5

Net Inter-Regional Natural Gas Trade Flow, 2030(bcm, source: IEA, 2002)

17

79

104

6

Agenda

1. The Issue: Internationalization of Natural Gas Markets

2. Theory and Data

3. Model 1: Cointegration of International Gas Prices

4. Model 2: Convergence of Trans-Atlantic Gas Prices

5. Conclusions

7

2. Theory:Cointegration, the Law of One Price (LOP), and Convergence

Cointegration:

- xt, a N-dimensional process, is co-integrated if each component of the process is I(1) but there exists

v, a N-dimensional vector, such that v‘xt is I(0) Johansen Test ~ Model 1

Law of one price:- LOP is equivalent to having every relative price in the system constant in the long term

α ~ transportation costs, quality, risk premium, etc.

β ~ relationship between the prices β = 0 no market integration

β = 1 LOP holds; markets are fully integrated; proportionate prices

Convergence:

- A dynamic structural change, time-varying coefficient models Kalman Filter ~ Model 2

β(t) ~ relationship between the prices

β = 0 no market integration

β = 1 LOP holds; markets are fully integrated

β 1 increasing market integration over time

lnp1 = α + β*lnp2 +et

lnp1t = α(t) + β(t)*lnp2t + et

8

Literature: Integration of regional gas markets

• North America

- De Vany and Walls (1995): Gas spot prices in several locations (hubs) are

increasingly cointegrated with open access to the pipelines (post FERC Order 436)

- King and Cuc (1996): price convergence in regional markets, but also a “split”

between Eastern and Western region

- Serletis (1997): Bi- and multivariate tests for co-integration, indicating that North

American natural gas spot markets are integrated (no “split”)

• Europe (Asche, Osmundsen, Tveteras, 2001, 2002)

- Cointegration of European gas import prices (from Russia, Norway, Netherlands)

- Cointegration of domestic gas prices, e.g. Belgium, France, Germany

9

Prices Used in this Study

Henry Hub

Pipe USA

LNG USA

Pipe Europe

LNG Europe LNG Japan

Brent

10

Monthly DataSummary Statistics (until mid-2002)

Variable No. of obs.

Mean Std. Dev. Min Max Skew. Kurt.

Brent Level

Log156

3.68

1.27

0.96

0.26

1.80

0.59

6.63

1.89

0.72

0.02

3.31

2.95

Pipe Europe Level

Log127

2.65

0.96

0.44

0.17

1.68

0.52

3.90

1.36

0.47

-0.18

3.83

3.71

LNG Europe Level

Log64

2.84

1.02

0.63

0.23

1.80

0.59

4.10

1.41

0.15

-0.25

2.27

2.24

LNG Japan Level

Log127

3.74

1.31

0.59

0.15

2.74

1.01

5.12

1.63

0.48

0.17

2.51

2.42

Henry Hub Level

Log109

2.73

0.93

1.24

0.37

1.42

0.35

8.50

2.14

2.31

0.97

9.93

3.94

Pipe USA Level

Log114

2.43

0.81

1.22

0.36

1.34

0.29

9.45

2.25

3.00

1.49

14.25

5.54

LNG USA Level

Log104

2.80

1.00

0.78

0.24

1.77

0.57

6.41

1.86

2.05

1.01

8.76

4.65

11

Unit Root TestsAll variables are I(1)

Market Log Levels First difference of log Levels

ADF PP ADF PP

Brent -1.88 -1.91 -3.85*** -9.55***

LNG USA -1.75 -2.65* -5.47*** -13.44***

LNG Europe -1.45 -1.10 -2.31 -6.21***

Pipe Europe -2.06 -1.74 -4.08*** -10.00***

LNG Japan -2.17 -1.63 -2.86* -9.57***

Henry Hub -2.07 -2.22 -4.10*** -8.50***

Pipe USA -1.94 -1.91 -5.74*** -9.55***

Tests for prices in level use a constant but not a time trend. Tests for first differences are performed with neither intercept nor linear trend. One / two / three asterisks indicate significance at the 10% / 5% / 1 % level, respectively.

12

Agenda

1. The Issue: Internationalization of Natural Gas Markets

2. Theory and Data

3. Model 1: Cointegration of International Gas Prices

4. Model 2: Convergence of Trans-Atlantic Gas Prices

5. Conclusions

13

European LNG, European Pipeline and Japanese LNG (logged) are largely cointegrated …

0

0,2

0,4

0,6

0,8

1

1,2

1,4

1,6

1,8

2

Jan

93

Jul 9

3

Jan

94

Jul 9

4

Jan

95

Jul 9

5

Jan

96

Jul 9

6

Jan

97

Jul 9

7

Jan

98

Jul 9

8

Jan

99

Jul 9

9

Jan

00

Jul 0

0

Jan

01

Jul 0

1

Jan

02

Jul 0

2

Jan

03

Jul 0

3

LNG EuropePipeline EuropeLNG JapanBrent

14

… and so are American LNG, American Pipeline and

Henry Hub (logged), at least since 1999

0

0,5

1

1,5

2

2,5

Jul 9

6

Nov

96

Mrz

97

Jul 9

7

Nov

97

Mrz

98

Jul 9

8

Nov

98

Mrz

99

Jul 9

9

Nov

99

Mrz

00

Jul 0

0

Nov

00

Mrz

01

Jul 0

1

Nov

01

Mrz

02

Jul 0

2

Nov

02

Mrz

03

Jul 0

3

Nov

03

LNG USA

Pipeline USA

Henry Hub

15

But: European and North American Prices?

0

0.5

1

1.5

2

2.5Pipeline Europe

Henry Hub

LNG Europe

16

Bivariate Johansen Test ResultsSupport for the “regional divide”

Henry Hub Pipe USA LNG USA LNG Europe Brent LNG Japan

Pipe

USA

11.25*

18.07*

4.44**

LNG

USA

16.44***

27.75***

7.75***

14.60**

38.42***

19.58***

LNG

Europe

15.05**

17.69

0.30

12.75**

15.86

0.12

7.54

9.97

Brent 6.23

12.99

5.36

9.13

13.93**

16.57

0.64

30.23***

33.89***

0.30

LNG

Japan

7.64

18.37*

5.83**

3.84

13.25

8.21

14.12

26.02***

42.60***

12.28***

14.50**

59.37***

41.10***

Pipe

Europe

8.46

13.37

7.37

10.88

7.04

10.19

16.88***

21.00**

1.74

26.73***

34.45***

0.02

10.26

19.60*

2.93*

Cointegration

No evidence of cointegration

- First Line = VECM1 (neither intercept nor trend) in CE

- Second Line = VECM 2 (without trend) in CE

- Third Line = LR trace statistic to restrict VECM 2 to VECM 1

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Estimated Cointegration Vector and the Law of One Price(selected statistics)

Pair

LOP

Likelihood Ratio

Cointegration Vector

(stand. err.)

LNG Europe,

Brent23.25***

1, -0.80

(0.02)

Brent,

LNG Japan39.2***

1, -1.51

(0.04)

LNG Europe,

LNG Japan 1.65

1, -0.87

(0.14)

Henry Hub,

LNG USA6.66***

1, -0.67

(0.07)

LNG USA,

Pipe USA16.21***

1, -0.59

(0.05)

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Results from Model 1:Regional Market Integration, but not Trans-Atlantic

Henry Hub

Pipe USA

LNG USA

Pipe Europe

LNG Europe LNG Japan

Brent

19

Agenda

1. The Issue: Internationalization of Natural Gas Markets

2. Theory and Data

3. Model 1: Cointegration of International Gas Prices

4. Model 2: Convergence of Trans-Atlantic Gas Prices

5. Conclusions

20

Towards Cointegration of Spot Gas Pricesin Europe and North America?

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00$/Mbtu

NBP Henry Hub

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Kalman Filter (NBP – Henry Hub)

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

1996 1997 1998 1999 2000 2001 2002 2003

- Two periods of “convergence“, stronger relations in winter periodsSome linkage between North American and European gas prices, but by far not

systematic

22

Agenda

1. The Issue: Internationalization of Natural Gas Markets

2. Theory and Data

3. Model 1: Cointegration of International Gas Prices

4. Model 2: Convergence of Trans-Atlantic Gas Prices

5. Conclusions

23

5. Conclusions

-The European/Japanese natural gas markets and the North American markets seem to be highly integrated within themselves

- Even so, the law of one price does not hold in any of the regional price relations

- For the period under observation, there seems to be no integration between the gas markets in Europe/Japan and North America

- However, analysis of recent data indicates at least some convergence between European and North American gas prices

The dynamic evolution of the trans-atlantic market, with increasing spot-trading and arbitrage, might lead to a further integration of European and North American gas markets and prices

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Hypothesis for Further Research:Trans-Atlantic Market Integration

Henry Hub

Pipe USA

LNG USA

Pipe Europe

LNG Europe LNG Japan

Brent

25

Literature

Asche, Frank, Petter Osmundsen, and Ragnar Tveteras (2001): Market Integration for Natural Gas in Europe. International Journal of Global Energy Issues, Vol. 16, No. 4, 300-312.

Asche, Frank, Petter Osmundsen, and Ragnar Tveteras (2002): European Market Integration for Gas ? Volume Flexibility and Political Risk. Energy Economics, Vol. 24, 249-265.

De Vany, Arthur and David Walls (1993): Pipeline Access and Market Integration in the Natural Gas Industry: Evidence from Cointegration Tests. The Energy Journal, Vol. 14, No. 4, 1-19.

De Vany, Arthur and David Walls (1993): The Emerging New Order in Natural Gas – Market versus Regulation. Querum Books, Westport.

Deutsche Bank (2003): LNG: going… going… Gone Global. Global Equity Research.Engle, Robert F. and Clive W.J. Granger (1987): Cointegration and Error Correction: Repreentation, Estimation and

Testing. Econometrica, Vol. 55, 251-276.European Commission (2001): Green Paper – Towards a European Strategy for the Security of Energy Supply.

Luxembourg, Commission Document COM(2000)769final.Hartley, Peter R., and Dagobert L. Brito (2001): New Energy Technologies in the Natural Gas Sectors. Houston,

Texas, The James A. Baker III Institute for Public Policy.Hendry, D. and K. Juselius (1999): Explaining Cointegation Analysis: Part II. Oxford, Nuffield College, Lecture Notes.International Energy Agency (2002): Flexibility in Natural Gas Supply and Demand. Paris, OECD.International Energy Agency (2004): Security of Gas Supply in Open Markets – LNG and Power at a Turning Point.

Paris, OECD.Jensen, James (2003): The LNG Revolution. The Energy Journal, Vol. 24, 1-45.Johansen, S. (1988): Statistical Analyis of Cointegration Vectors. Journal of Economic Dynamics and Control, Vol.

12, 231-254King, Martin and Milan Cuc (1996): Price Convergence in North American Natural Gas Spot Markets. The Energy

Journal, Vol. 17, No.2, 17-42.Meinhold, Richard and Nozer Singpurwalla (1983): Understanding the Kalman Filter. The American Statistician, Vol.

37, No. 2, 123-127Serletis, Apostoles (1997): Is there an East-West Split in North American Natural Gas Markets? The Energy Journal

Vol. 1, 47-62.Serletis, Apostoles and J. Herbert (1999): The Message in North American Energy Prices. Energy Economics Vol.

21, 471-483.

26

BACKUP

27

Data (USD/Mbtu)

0

1

2

3

4

5

6

7

8

9

No

v-93

No

v-94

No

v-95

No

v-96

No

v-97

No

v-98

No

v-99

No

v-00

No

v-01

No

v-02

No

v-03

Henry Hub

0

1

2

3

4

5

6

7

Ja

n-9

0

Ja

n-9

2

Ja

n-9

4

Ja

n-9

6

Ja

n-9

8

Ja

n-0

0

Ja

n-0

2

Brent

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

Jan

-92

Jan

-94

Jan

-96

Jan

-98

Jan

-00

Jan

-02

Pipeline Europe

Sources: IEA „Energy Prices and Taxes“ (several issues); Oil and Gas Journal Database (Henry Hub)

28

Multivariate Johansen Test Results

Group

Trace Statistic Likelihood Ratio Statistic

r = 0 r ≤ 1Model 1/

Model 2

Price out of coint. space

LNG Japan, Brent,

Henry Hub

24.19***

65.68***

5.83

14.2133.12***

Henry Hub

0.08

LNG Europe, LNG USA,

Henry Hub

36.00***

52.13***

12.00*

13.6014.52***

LNG Europe

0.50

LNG Europe, LNG USA,

Pipe USA

21.00

42.04***

7.96

13.3215.7***

LNG Europe

0.48

Brent, LNG Europe,

LNG USA

37.46***

41.32

8.37

12.010.12 LNG USA

LNG Europe, LNG Japan,

LNG USA

39.80***

58.03***

9.29

13.5714.96***

LNG USA

4.67**