Drill-Bit Parity: The Increasing Importance of Supply-Side Links in Oil and Gas Markets

Abstract

Previous economic analyses focused on relationships between crude oil and natural gas markets centered primarily on demand-side considerations. We provide evidence that two important supply-side connections play important roles in understanding crude oil and natural gas market integration. First, crude oil production and natural gas production require a common capital input: rotary drilling rigs. Competition for this capital input should be expected to keep the difference between crude oil and natural gas prices in check. Second, crude oil wells produce associated gas, while natural gas wells often produce associated oil or oil substitutes. This latter supply-side connection could cause divergence in crude oil prices and natural gas prices, because a price shock for one commodity will increase associated production of the other commodity. Understanding which effect dominates at a particular time is essential to understanding oil and gas market integration. We construct a theoretical model based on the profit-maximizing decisions of a drilling-rig allocating firm to delineate the role played by these supply-side factors in oil and gas market integration. If rig competition is the more important supply-side factor then gas-rig allocations and oil prices will be negatively related, and vice versa, while if associated commodity flows are more important then gas-rig allocations and oil prices will be positively related, and vice versa. We then test the predictions of the theoretical model using three econometric methods, and find ample evidence of long-run relationships driven by these supply-side factors. However, we provide evidence indicating that drilling responses to price changes are unstable across time, and drilling rig competition has come to play a more important role since the onset of increasing production from shale gas and tight oil wells, which began in the mid-2000’s.