Is hub-based pricing a better choice than oil indexation for natural gas? Evidence from a multiple bubble test

Abstract

Oil indexation and hub-based pricing are two competing pricing mechanisms in the international natural gas markets. The debates over whether hub-based pricing is preferable to oil indexation have become intense among academics and practitioners, for example, whether and when East Asia should adopt hub pricing. This paper contributes empirically to the debate using a multiple bubble test. Adopting the generalized sup augmented Dickey-Fuller test proposed by Phillips et al. (2015), we show that more explosive bubbles exist in Japan and European gas prices than in the US prices. The argument is that hub-based pricing mechanism can better reflect fundamental values in the gas markets and thus is less subject to speculations. Given the recent trend of financialization in energy markets, gas prices are more likely to deviate from fundamental values when they are not clear to investors. Although oil indexation is simple and has been an effective tool over the past few decades, our results suggest that hub pricing is associated with less extreme price movements in the market and thus is a better choice for both policy makers and practitioners.