The switching relationship between natural gas and crude oil prices

In this analysis we more accurately capture the cointegrating relationship between natural gas and crude oil prices by endogenously incorporating shifts in the cointegrating vector into the estimation of the cointegrating equation. Specifically, we allow the cointegrating equation to switch between m states, according to a first-order Markov process. First, we find evidence that regime-switching exists in the relative pricing relationship, and that two is the optimal number of states. Once we control for shifts in the cointegrating vector, we find that natural gas and crude oil prices are cointegrated, and an error correction model (ECM) of their long-term equilibrium relationship is properly specified. This finding broadens the ECM model of their relationship to longer and more varied sample periods. Also, in a direct comparison of the two and one state cointegrating equations, we found evidence of the potential superiority of the two-state equation, in that it may be robust to shifts in the cointegrating vector which are missed by standard tests for a unit root. Further, our analysis finds evidence that natural gas and crude oil prices did not permanently 'decouple' in the early 2000s, but rather experienced a temporary shift in regimes. We find that forecasts of the relative pricing of natural gas and crude oil should be conditioned on state probability.