24 C. Bencivenga, G. Sargenti, and R.L. D’Ecclesia
switch between natural gas and residual fuel oil has declined, so gas prices seem to
move more independently from oil prices. However, to a certain extent, oil prices are
expected to remain the main drivers of energy prices through inter-fuel competition
and price indexation clauses in some long-term gas contracts.
Finally, the high price volatility in the energy commodity markets boosted the
development of energy derivative instruments largely used for risk management. In
particular, spread options have been largely used, given that the most useful and
important structure in the world of energy is represented by the spread.^1 The joint
behaviour of commodity prices as well as gas, oil and electricity, is crucial for a
proper valuation of spread contracts. This requires a real understanding of the nature
of volatility and correlation in energy markets.
The aim of this paper is twofold. First, to investigate the short-run relationship
between oil, natural gas and electricity in the European energy markets. Second, to
identify possible long-run equilibrium relationships between these commodities. In
particular we test for shared price trends, or common trends, in order to detect if
natural gas and electricity are driven by a unique source of randomness, crude oil. In
a financial context the existence of cointegrating relationships implies no arbitrage
opportunity between these markets as well as no leading market in the price discovery
process. This is going to be a key feature for the definition of hedging strategies also
for energy markets, given the recent deregulation process of the gas and the electricity
market in Europe.
The paper is organised as follows. Section 2 provides an overview of the rele-
vant literature on this topic. Section 3 describes the data set given by daily prices of
electricity, oil and natural gas for the European market over the period 2001–2007 and
examines the annualised quarterly volatilities ofeach time series. In Sections 4 and
5 current state of the art methodologies are used to analyse the short- and long-run
relationships, as well as a rolling correlation and cointegration approach. Section 6
draws some preliminary conclusions.
2 Relevant literature
Economic theory suggests the existence of a relationship between natural gas and
oil prices. Oil and natural gas are competitive substitutes and complements in the
electricity generation and in industrial production. Due to the asymmetric relationship
in the relative size of each market, past changes in the price of oil caused changes in
the natural gas market, but the converse did not hold [17].
The relationship between natural gas and crude oil has been largely investigated.
In [14] UK gas and Brent oil prices over the period 1996–2003 have been analysed.
In [3] the degree of market integration both among and between the crude oil, coal,
and natural gas markets in the US has been investigated. A longer time period 1989–
2005, is used in [17] where a cointegration relationship between oil and natural gas
(^1) Spreads are price differentials between two commodities and are largely used to describe
power plant refineries, storage facilities and transmission lines. For an extensive description
of energy spread options, see [6].