Supply and demand determinants of natural gas price volatility in the U.K.: A vector autoregression approach

Since 2008, the U.K. natural gas market has witnessed a marked drop in volatility. This fall has coincided with specific events in oil and gas sector such as the onset of the U.S. “shale gas revolution” and the subsequent rerouting of liquefied natural gas (LNG) shipments from the U.S. to other markets such as Asia and Europe. LNG cargoes, along with other sources of flexibility such as underground storages and interconnector import, can potentially reduce volatility. On the other hand, demand shocks can increase volatility. To examine the dynamics relationship between daily shocks in U.K. gas demand and supply, and the gas spot price volatility, we use a vector autoregressive (VAR) model. While we find evidence that daily deviations in aggregated gas demand significantly impacts volatility, we are unable to find direct evidence for an impact from shocks in disaggregated demand or supply. In fact, one important contribution of the paper is to suggest that flexible sources of supply such as LNG, storage and interconnector flows react to shocks in retail demand, dampening their potential effects on volatility.