For traders active in the energy sector, crude oil and natural gas are often the most concerned. There has been controversy about how oil and natural gas prices are related and to what extent. This article explores the relationship between crude oil and natural gas prices.
- The chart comparison of crude oil and natural gas from 2017 to 2019 shows minimal correlation.
- EIA data shows that there was a strong correlation between crude oil and natural gas from 2003 to 2008, but there was almost no correlation between 2009 and 2020.
- The increase in shale production in the United States provides a possible explanation for the decoupling of crude oil and natural gas prices, because natural gas is a regionalized product.
- There may be a stronger correlation between these two commodities, because oil and natural gas are close substitutes for each other.
Historical crude oil and natural gas prices
Let’s start with the historical price observation of two assets to set the context. The following two charts show the prices of Brent crude oil (an oil that provides a benchmark for world oil prices) and natural gas in the past three years.
Crude oil chart
Natural gas chart
The above chart shows that these two commodities mainly fell sideways in the first six months of 2017. However, from June of that year to May 2018, crude oil prices showed an upward trend, while natural gas prices were relatively flat. Although the sell-off of crude oil started in early October and natural gas prices did not start to fall until December, both assets fell sharply in the fourth quarter of 2018.
Prices began to diverge again in 2019. Oil prices rebounded from January to April, while natural gas prices continued to fall. From June to the end of 2019, crude oil prices traded sideways, and natural gas prices rose slightly.
From the above observations, there seems to be little correlation between crude oil and natural gas prices over the broader three-year period reviewed. However, viewing other data sources may provide different views. The U.S. Energy Information Administration (EIA) provides historical data for research on the correlation between crude oil and other commodities. The following table is constructed based on quarterly data and shows the correlation between natural gas and Brent crude oil price changes.
Relevance: Understanding the numbers
Simply put, the correlation between the prices of two assets is the degree to which the price changes of one asset are similar to the price changes of another asset. The correlation coefficient between crude oil and natural gas is 0.25, indicating that changes in oil prices can account for 25% of the changes in natural gas prices (averaged over the entire study period). Correlation is not a causal indicator; instead, it only shows how much similarity (up and down together) exists between the price patterns of two assets. We can observe the following information from the above table:
From 2003 to 2008, there was an obvious positive correlation between the two commodities, ranging from 0.25 to >0.65. The positive correlation reached its peak in the second quarter of 2004 (Q2) and the second and third quarters of 2005, and at the same time showed a strong relationship in every quarter of 2008. However, the data shows that the correlation between 2009 and 2020 is very small, except for irregular quarters.
The rationale behind changing relevance
Revolutionary hydraulic fracturing and horizontal drilling technologies have significantly increased U.S. shale production, providing a possible explanation for the decoupling of crude oil and natural gas prices in the past decade. Since natural gas is a regional product and oil is a global commodity, the increase in domestic production has depressed the price of this commodity relative to the price of oil.
However, because oil and natural gas are close substitutes for each other, there may be stronger correlations again. The end consumer can now switch between fuels. For example, companies can use power plants that can switch between oil and natural gas, or consumers can use dual-power vehicles. If the price of one energy source rises sharply, consumers can choose to use another energy source. This increases the demand for secondary energy, and its price rises accordingly.
The above observations indicate that oil has always been the dominant factor in any observed relationship between crude oil and natural gas prices (in other words, oil prices tend to affect natural gas prices and vice versa).
Based on the price patterns observed in the past decade, it is difficult to make clear conclusions about the correlation between crude oil and natural gas prices. The United States is one of the few countries that seems to have a balanced infrastructure and mature oil and gas markets. However, as other markets in the world rely more on oil, the true relationship between oil and natural gas is still inconclusive, and there are signs that oil is the driving factor.