The Determinants of Regime Switching in the Natural Gas and Crude Oil Cointegrating Relationship

Abstract

The goal of this analysis is to find determinants of the endogenous regime-switching process underlying the cointegrating relationship between natural gas and crude oil. We do so by modeling the cointegrating equation as a two-state, Markov-switching process with time-varying transition probabilities. Many factors across energy markets and the macroeconomy were tried. Ultimately, we found that regime switching in the cointegrating relationship was driven by (a) natural gas supplies (though not crude oil supplies), (b) the deviation of the number of heating degree days from average (reflecting natural gas demand) and (c) the collapse of Enron. This result is consistent with previous research, which found crude oil to be exogenous in the cointegrating relationship. Last, we found that macroeconomic data has no effect on the transition probabilities.

Keywords: natural gas, crude oil, relative pricing, cointegration, regime-switching models