Energy Economics 24 (2002) 525–538

Volatility transmission in the oil and natural gas

markets
Bradley T. Ewinga,*, Farooq Malikb, Ozkan Ozfidanc
a
Department of Economics, Texas Tech University, Lubbock, TX 79409-1014, USA
b
Department of Economics and Finance, Penn State University–Berks Campus, Reading,
PA 19610-6009, USA
c
Virginia Department of Planning and Budget, Richmond, VA 23219, USA

Abstract

This research looks at how volatility in the oil and natural gas sectors changes over time
and across markets. We empirically examine the univariate and bivariate time-series properties
of oil and natural gas index returns, allowing for non-linearity in the variance of each series,
as well as for the possibility that changes in volatility in one market may spill over to the
other market. Patterns in volatility transmission emerge that may be of practical importance
to financial market participants. 䊚 2002 Elsevier Science B.V. All rights reserved.

Keywords: Market volatility; Oil and natural gas; Time series

1. Introduction

The increasing integration of major financial markets throughout the world has
generated interest in examining the transmission of financial market shocks across
markets. In particular, there has been considerable interest in examining whether or
not conditional (or predictable) volatility is transmitted across markets; however,
the idea that volatility in one market may spill over to another is not new. In fact,
since the well-known articles of Shiller (1981a,b), much attention has focused on
modeling the volatility of equity markets and on determining the extent to which
*Corresponding author. Tel.: q1-806-742-2201.
E-mail address: bewing@ttacs.ttu.edu (B.T. Ewing).

0140-9883/02/$ - see front matter 䊚 (2002) Elsevier Science B.V. All rights reserved.
PII: S 0 1 4 0 - 9 8 8 3 Ž 0 2 . 0 0 0 6 0 - 9
526 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538

inter-relationships among international asset markets exist. Notable papers that have
examined the transmission of volatility across financial markets include those by
Goodhart (1988), Hamao et al. (1990), King and Wadhwani (1990), Ng et al.
(1991), Cheung and Kwan (1992), Engle and Susmel (1993), Theodossiou and Lee
(1993), Lin et al. (1994), King et al. (1994), Kim and Rogers (1995), Karolyi
(1995), Darbar and Deb (1997), and Stokes and Neuburger (1998).
This paper looks at how volatility in the oil and natural gas sectors changes over
time and across markets. Since different assets are traded in the market based on
these energy sector indexes, it is important for financial market participants to
understand the volatility transmission mechanism across time and sectors in order
to facilitate optimal portfolio allocation decisions. In particular, we empirically
examine the univariate and bivariate time-series properties of oil and natural gas
index returns. The methodology we employ is robust, in that it is capable of
handling non-linearity in the variance of each series, as well as allowing for the
possibility that changes in volatility in one energy market may spill over to the
other energy market. Volatility is often interpreted as a proxy for information flow
(e.g. Chan et al., 1991). It is natural to be concerned with how information, and
therefore volatility, may flow from one market to another. Since index options are
one tool that financial market participants can use to hedge against portfolio risk,
and because the volatility of the index price is a key determinant of option valuation,
it is important to understand what affects index volatility in these markets.

2. Volatility persistence and transmission

Two stylized facts about financial asset prices are that they tend to be processes
that are integrated of order one, I(1), and their corresponding returns are leptokurtic.
The former property is often taken as evidence consistent with the weak-form
efficient markets hypothesis.1 In particular, shocks to (the mean of) an I(1) series
are permanent, whereas shocks to the first-difference of the series are transitory in
nature. The latter property often manifests as volatility clustering and suggests that
the conditional variance of the return series may not be constant. This time-varying
property implies that shocks to the series affect volatility for several, if not many,
periods into the future. Knowledge about the persistence of volatility can enable
researchers to obtain more efficient parameter estimates, as persistence suggests that
current volatility can be predicted. While a number of techniques have been used
to model volatility, the autoregressive conditional heteroscedasticity (ARCH) model
developed by Engle (1982), and later generalized by Bollerslev (1986), is by far
the most popular method used for analyzing high-frequency financial time series
data.2
The increasing integration of major financial markets has generated concern for
understanding the spillover effects of volatility from one market to another. These
spillovers are usually attributed to cross-market hedging and changes in common
1
According to Campbell et al. (1997), a financial asset is weak-form efficient if information contained
in past observations (i.e. the history of the series) is incorporated in the current return.
2
See Bollerslev et al. (1992) for a detailed survey.
 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538 527

information, which may simultaneously alter expectations across markets. For

example, Engle et al. (1990) argued that volatility in one foreign exchange market
is transmitted to other foreign exchange markets. They describe this phenomenon
as being like a ‘meteor shower’.
Multivariate generalized autoregressive conditional heteroscedasticity (GARCH)
models have been used to estimate the spillover effects in mean andyor volatility
among different markets. This technique was used by Kearney and Patton (2000)
to detect significant transmission of volatility in exchange rates in the European
monetary system. The multivariate GARCH model was also employed by Chou et
al. (1999) to investigate spillovers between the stock markets of Taiwan and the
US.3
Recent turmoil in energy markets has sparked renewed interest in studying the
interaction across different energy sectors. Soderholm (2000) analyzed the implica-
tions of fuel flexibility (i.e. the ability to substitute various fuel inputs in the
production process) in responding to fuel supply interruptions and short-term fuel
price differentials for eight Western European countries. His findings indicate that
there is substantial substitution between oil and natural gas. He attributes this finding
to (a) heavy use of oil and gas in peak power production and (b) the ease with
which oil-fired plants can burn gas or oilygas.
Serletis and Herbert (1999) studied the time-series characteristics of industrial
prices for natural gas, fuel oil and power using daily data from 25 October 1996 to
21 November 1997. They found that gas and fuel oil prices are both integrated of
order one, I(1), and co-integrated. They take these findings as evidence of a high
degree of price competition in the natural gas and oil markets where all profit
opportunities are exploited. Their results appear to suggest that an effective
arbitraging mechanism for the price of natural gas and fuel oil exists. They reiterate
that the natural gas and oil price series are related because fuel oil and natural gas
are used as substitutes in the industrial process and both are used in peak power
production.4 The above-mentioned studies suggest that oil and natural gas markets
are linked and may respond to common information.
This paper builds on the previous research by moving from the physical dimension
of commodity markets to financial relationships across financial markets. Surpris-
ingly, most studies of energy markets focus on price spillover effects across sectors
and ignore the possibility of volatility spillovers. The present paper fills a gap in
the literature by modeling time-varying conditional variances of returns calculated
from natural gas and oil sector indexes and testing for the presence of volatility
transmission between these energy markets. We estimate a multivariate GARCH
model to simultaneously estimate the mean and conditional variance of daily returns
in the natural gas and oil markets, thus avoiding the generated regressor problem
associated with the two-step estimation process found in many earlier studies
3
Other recent studies of mean andyor volatility spillover include Liu and Pan (1997) and Hamao et
al. (1990) for the equities market, Fung et al. (1996) for the interest rate market, and Pan and Hsueh
(1998) for the futures market.
4
Estrada and Fugleberg (1989) also found that natural gas and oil are substitutes in the case of
France and former West Germany.
528 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538

(Pagan, 1984). In addition, we use the BEKK specification of the multivariate

GARCH model, which does not impose the restriction of constant correlation
between index returns.

3. Data, methodology and results

In order to examine the transmission of volatility between the oil and natural gas
financial markets, we use two widely watched indexes that represent the behavior
of the stock prices of major companies in the oil and natural gas markets. By
capturing movements in stock prices, these indexes effectively measure oil and gas
company performance. The oil index is comprised of 15 widely held corporations
and is designed to represent the overall oil industry. The oil index is price-weighted
(i.e. each stock affects the index in proportion to its price per share) and provides
information as to how oil company stock prices change over time. American style
options are traded on the American Stock Exchange (AMEX) based on this index.
The natural gas index is equal-dollar weighted and based on 15 highly capitalized
companies in the natural gas industry. European style options are traded on the
AMEX based on this index. The trading symbols for the natural gas and oil option
indexes are XNG and XOI, respectively.5 Thus, volatility in the energy sector will
result in volatility in the financial sector. While we do not explicitly analyze option
prices, our results have implication for option pricing, as the price of an option
price is intrinsically related to its time to maturity, which changes on a daily basis.
The data are daily closing values for the period from 1 April 1996 to 29 October
1999.6
Preliminary analyses determined that each variable was integrated of order one,
I(1). Consistent with earlier research, we used growth rates to attain stationarity.
These growth rates were calculated as first-differences of natural logarithms.7 Thus,
our analysis is conducted in first-differences of the indexes. Table 1 presents
descriptive statistics for the corresponding return series. Note that the standard
deviations for the series are of similar magnitude and that each exhibits evidence of
positive skewness. Both series are also leptokurtic, a fairly common occurrence in
high-frequency financial data, and thus it may be appropriate to model the process
using the generalized autoregressive conditional heteroscedasticity (GARCH)
approach of Bollerslev (1986). The Jarque–Bera statistic rejects the null hypothesis
of normality. It is also interesting to note that the Q-statistic for the presence of
autocorrelation is significant in the case of natural gas index returns. Thus, it may
5
Details of the AMEX indexes, including a list of the companies included in each index, are
available at http:yywww.amex.comyoptionsy.
6
We are indebted to Jennifer Burgett of Standard & Poor Corporation for assembling this data set.
The data set is restricted to this sample period due to availability from S&P at the time of acquisition.
7
It is interesting that Johansen–Juselius cointegration tests were unable to detect evidence of
cointegration in our data. This finding suggests that these two indexes adhere to the semi-strong form
of the efficient markets hypothesis, at least with respect to the information that is contained in the time
series history of the two series (see Campbell et al., 1997). Unit root and cointegration test results are
available on request.
 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538 529

Table 1
Descriptive statistics

Oil index returns (XOI) Natural gas index returns (XNG)

Mean 0.0004 6.90=10y7
S.D. 0.0120 0.0142
Skewness 0.1330 0.0621
Kurtosis 4.4374 4.5242
Jarque–Bera 82.9954 (0.000) 90.8177 (0.000)
Q(16) 19.07 (0.265) 30.23 (0.017)
The sample of daily returns covers the period from 1 April 1996 to 29 October 1999. The number of
usable observations is 932. Q(16) is the Ljung–Box statistic for serial correlation. The Jarque–Bera
statistic is used to test whether or not the series resembles normal distribution. Actual probability values
are in parentheses.

be that the past behavior of the natural gas market is more relevant in the gas sector
than it is in the oil sector.
Fig. 1 presents plots of the two return series, calculated as first-differences of the
natural logarithms of each index. There are two points of interest revealed in these
plots. First, upon close inspection, it appears that for each series there are periods
of high volatility that are followed by periods of high volatility. Similarly, periods
of low volatility may be followed by periods of low volatility. Thus, it is possible
that the series exhibit serial correlation of conditional variances (Mills, 1999). This
observation, known as volatility clustering, is consistent with the statistical finding
of excess kurtosis and suggests that the variance of the series may be time-varying.
Second, the two series often exhibit periods of relative tranquility (low volatility)
and periods of heightened volatility around the same time. For example, a period
of relatively low volatility occurs between observations 100 and 400 in both series,
whereas each series experienced relatively high volatility between observations 600
and800. This latter observation raises the question of whether or not there is
volatility transmission between these two series. Certainly, no definitive statements
should be made regarding time-varying volatility or volatility spillovers from a
cursory visual examination of the series. Thus, we proceed to a more formal time-
series examination that allows for the possibility that the variance of each series is
changing over time and that is capable of capturing volatility spillovers between the
oil and natural gas markets.
The first step in the procedure was to identify the best-fitting specification of the
(mean) return series using standard Box–Jenkins techniques.8 Consistent with earlier
research, the following mean return equation was chosen and estimated for each
series:
Ritsmiq´it (1)
where Rit is the return on index i between time ty1 and t (i.e. 1 trading day), mi
is a long-term drift coefficient and ´it is the error term for the return on index i at
8
See Mills (1999) for an overview of how one fits an ARMA model using Box–Jenkins techniques.
530 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538

Fig. 1. Returns in (a) oil and (b) natural gas markets. The sample of daily returns covers the period
from 1 April 1996 to 29 October 1999. The number of usable observations is 932.

time t. Eq. (1) was then tested for the existence of autoregressive conditional
heteroscedasticity (ARCH) using the test described in Engle (1982) (p. 1000). The
mean equation for both series exhibited evidence of ARCH effects. The test statistic
is distributed as a x2 with degrees of freedom equal to the number of restrictions.
Specifically, we found significant first-order ARCH effects in each series. This
finding suggests that past values of volatility can be used to predict current volatility.
Thus, estimation of a GARCH-class model is appropriate. However, since we are
also interested in the possibility of volatility transmission between the two markets,
 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538 531

as well as volatility persistence within each market, we employ a variant of the

multivariate GARCH model.
There are two popular parameterizations for the multivariate GARCH model.9
The VECH model, introduced by Bollerslev et al. (1988), is given by:
q p
vechŽHt.sA0q8BjvechŽHtyj.q8AjvechŽ´tyj´9tyj. (2)
js1 js1

where ´tsH1y2 t ht, ht;iid N(0,I). Here, Ht is the conditional variance matrix, and
the notation vech(Xt) implies a vector formed by stacking the columns of matrix
Xt. The total number of elements estimated for the variance equation in our bivariate
case is 21. Note that during estimation all elements must be constrained to be
positive in order to guarantee a positive semi-definite covariance matrix, which is a
rather formidable task.
A viable alternative to the above is the BEKK10 model of Engle and Kroner
(1995). This model incorporates quadratic forms so that the covariance matrix will
be positive semi-definite, a requirement that is needed to ensure that the estimated
variances are non-negative.
The BEKK parameterization for the multivariate GARCH(1,1) model can be
written as:
Htq1sC0CqB9HtBqA9´t´9tA (3)
where, in the bivariate case, C is a 2=2 lower triangular matrix with three
parameters and B is a 2=2 square matrix of parameters. The latter matrix depicts
the extent to which current levels of conditional variances are related to past
conditional variances. A is also a 2=2 square matrix of parameters and measures
the extent to which conditional variances are correlated with past squared errors
(i.e. deviations from the mean). The elements of A capture the effects of shocks or
events on volatility (conditional variance). In our case, the total number of estimated
parameters is 11.
The conditional variance for each equation can be expanded for the bivariate
GARCH(1,1) as:
2 2
h11,tq1sc11qb11h11,tq2b11b12h12,tqb221h22,tqa211´21,tq2a11a12´1,t´2,tqa221´22,t (4)
2 2 2 2 2 2
h22,tq1sc qc qb h
12 22 q2b12b22h12,tqb h
12 11,t 22 22,t qa ´ q2a12a22´1,t´2,t
12 1,t
2 2
qa ´ 22 2,t (5)

9
Other parameterizations for multivariate GARCH models include a constant correlation model,
which drastically reduces the number of parameters estimated by assuming constant correlations between
the variables across time. Some earlier studies (Karolyi, 1995; Bollerslev, 1990) used this assumption;
however, Longin and Solnik (1995) and Sheady (1997) contend that the assumption of constant
correlations across time does not hold for the equity markets and the foreign exchange markets. In
addition, the assumption is rather restrictive in the sense that it does not allow for cross-effects in the
variance equation. Our approach incorporates less restrictive assumptions.
10
The acronym BEKK is used in the literature, as an earlier draft of the published paper was written
by Baba, Engle, Kraft and Kroner (Baba et al., 1990).
532 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538

In Eq. (4) and Eq. (5), the elements contained in the matrices of Eq. (3) are given
by their corresponding lowercase letters, where subscripts (kj, t) denote row, column
and time period, respectively. Eq. (4) and Eq. (5) reveal how shocks and volatility
are transmitted across time and across the oil and natural gas sectors.11
The following likelihood function is maximized assuming normally distributed
errors:12
1 T
LŽu.syTlnŽ2p.y ŽlnZHtZq´9tHty1´t. (6)
28
ts1

where T is the number of observations and u represents the parameter vector to be

estimated. Numerical maximization techniques were used to maximize this non-
linear log likelihood function. Following the recommendations of Engle and Kroner
(1995), several iterations were performed with the simplex algorithm to obtain the
initial conditions. The BHHH algorithm was then employed to obtain the final
estimate of the variance-covariance matrix and corresponding standard errors.
The results of estimating the multivariate GARCH model with BEKK parameter-
ization for each variance equation are reported in Table 2.13 Our findings indicate
that volatility (conditional variance) in oil returns is directly affected by its own
volatility and by the volatility in the natural gas returns. Higher levels of conditional
volatility in the past are associated with higher conditional volatility in the current
period (see the positive and significant coefficients on h11 and h22). Moreover, the
coefficient for the covariance term (h12 ) in the conditional variance equation for oil
returns is statistically significant. This latter finding implies indirect volatility
transmission through the covariance term from natural gas returns to oil returns.
Thus, we find significant direct and indirect transmission of volatility from the
natural gas sector to the oil sector. Our results do not indicate that volatility in oil
returns is affected by shocks originating in either the oil sector (note the insignificant
estimated coefficient on ´21) or gas sector (note the insignificant estimated coefficient
on ´22). In addition, the estimated coefficient on the cross-error term (´1´2) is
insignificant, suggesting the absence of an indirect effect of shocks in the natural
gas sector on the oil sector.
The behavior of natural gas return volatility differs from that of oil. The results
indicate that volatility in natural gas returns is not affected by its own volatility
(note the insignificant estimated coefficient on h22 ) and is affected by volatility of
oil returns only at the 10% level of significance, as indicated by the estimated
11
Note that the coefficient terms in Eq. (4) and Eq. (5) are a non-linear function of the estimated
elements from Eq. (3). A first-order Taylor expansion around the mean was used in order to calculate
the standard errors for these coefficient terms (see, for example, Kearney and Patton, 2000 for more on
the use of this methodology to obtain standard errors).
12
Under quasi-maximum likelihood estimation, where the model is estimated assuming normality
when the true distribution is non-normal, the estimates are consistent, but standard errors may be biased.
We re-estimated the model, correcting the standard errors using the method of Bollerslev and Wooldridge
(1992), and obtained similar results, indicating that the results are not sensitive to the assumption of
normality.
13
All individual elements (except a21) of matrix A and matrix B in Eq. (3) were significant at the
5% level.
 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538
Table 2
Results of multivariate GARCH model (BEKK parameterization)

Oil conditional variance equation

h11,tq1s 1.0662=10y7q 2.2013h11,ty 2.8161h12,tq 0.9006h22,tq 0.0254´21,tq 0.0223´1,t´2,tq 0.0048´22,t
5.29=10y5 0.7224 0.9193 0.3545 0.0244 0.0160 0.0094
(0.0020) (3.0472) (y3.0632) (2.5400) (1.0411) (1.3885) (0.5198)
Natural gas conditional variance equation
h22,tq1s 6.7942=10y5q 1.3226h11,ty 1.3929h12,tq 0.3667h22,tq 0.0692´21,tq 0.1641´1,t´2,tq 0.0973´22,t
8.16=10y4 0.7868 0.9290 0.2953 0.0385 0.0369 0.0443
(0.0831) (1.6808) (y1.4992) (1.2419) (1.7961) (4.4374) (2.1935)
Volatility persistence comparison
Oil index (XOI) return 0.33853
Natural gas index (XNG) return 0.62710
h11 and h22 denote the conditional variance for the oil and natural gas return series, respectively. Directly below the estimated coefficients are the standard
errors, with the corresponding t-values given in parentheses. The mean equations include a constant term.

533
534 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538

coefficient on h11.14 Interestingly, volatility in natural gas returns is directly affected

by shocks (events or ‘news’) originating in the natural gas sector (see the positive
and significant coefficient on ´22) and indirectly by shocks in oil returns via the
cross-error term (see the significant coefficient on ´1 ´2 ). Thus, our findings suggest
that volatility in the natural gas sector is directly affected by events in its own
sector and indirectly by events originating in the oil sector.
Table 2 also provides estimates of the persistence in volatility for each return
series.15 The estimates of volatility persistence provide information about the extent
to which past shocks and volatility matter in the construction of forecasts of future
conditional variance. The greater the persistence, the more weight that should be
given to recent observations of volatility in terms of explaining future volatility.
Lesser degrees of persistence imply placing less weight on recent observations of
volatility in terms of forecasting future values of volatility. This is because the
volatility of the series will return to its unconditional variance faster than would be
the case when there is greater persistence. Generally speaking, if there is no
persistence, then forecasts of future volatility will simply be given by the long-run
(or unconditional) variance of the series.
Models using high-frequency financial data often find this persistence value to be
very close to 1. A persistence value equal to 1 is indicative of an integrated GARCH
(or IGARCH) process. The IGARCH property implies that shocks to conditional
variance are permanently incorporated into future forecasts at all horizons. This is
similar to the random walk property that is often found in the price series of
financial assets (e.g. stocks). The results presented here indicate that shocks to
volatility are more persistent in the case of natural gas index returns than they are
in oil index returns. However, neither volatility persistence estimate is close to 1.
Table 2 also reports this measure of volatility persistence as approximately 0.34 for
oil index returns and 0.63 for natural gas index returns. Thus, the return of volatility
to its unconditional or long-run value is much quicker for oil than for natural gas
index returns.
An alternative way of interpreting this persistence is to compute the half-life of
an innovation or shock to the series. The half-life for oil index returns is estimated
to be 0.64, while that for natural gas index returns is 1.49. Thus, it takes less than
1 day for the effect of a shock in the oil index return series to lose half of its effect
on the variance of the oil returns. This compares to approximately 1.5 days for the
effect of a shock in the natural gas index return series to lose half of its effect on
the variance of the natural gas returns. For both markets, these effects on volatility
14
This is particularly interesting, as univariate GARCH estimation was performed separately on the
two index returns series. The results (not reported here) indicated that both GARCH and ARCH terms
for each returns series were significant at the 1% level. Thus, the finding of (weak) GARCH effects in
the bivariate setting underscores the importance of the role played by the interdependence of the two
markets in determining the volatility of natural gas returns. The univariate GARCH results are available
upon request.
15
Analogous to the univariate GARCH case, the persistence of volatility in the multivariate GARCH
model is computed by taking the sum of coefficients of lagged variances, covariances, squared error
terms and cross-product of error terms.
 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538 535

are transitory in nature and the unconditional variance is a mean-reverting process.

Consequently, researchers will find this type of model useful in making short-run
forecasts of volatility.
One practical implication of the present paper is in terms of option prices, which
are determined by the volatility of the underlying asset.16 Since options are heavily
traded on a formalized exchange based on these indexes (sectors), investors should
be interested in knowing how the volatility of these different indices (sectors)
changes over time and what leads to volatility changes. For example, we found that
a change in volatility for natural gas returns affects the volatility in oil returns (with
a lag). This means that investors holding options in the oil sector may benefit by
keeping a close eye on what is happening in the natural gas sector.
Consistent with Soderholm (2000), Serletis and Herbert (1999), and Estrada and
Fugleberg (1989), our findings indicate that there are significant volatility transmis-
sions between oil and natural gas sectors and that these effects are asymmetric. An
economic explanation of this result comes from the notion that oil and natural gas
exhibit some degree of substitutability. To the extent that these markets are dependent
(on each other as well as their past histories), we should expect to find significant
interaction among second moments. Furthermore, Ross (1989) contended that
changes in rates of the flow of information among markets results in different
volatility transmission patterns, as volatility is directly related to the rate of
information flow.

4. Concluding remarks

This paper has examined the transmission of volatility between the oil and natural
gas markets using daily returns data. Generally speaking, we find evidence of
volatility persistence in both markets. Thus, returns exhibit time-varying volatility.
It appears that volatility in natural gas returns is more persistent than volatility in
oil returns. By itself, this result suggests that there may be a ‘larger window of
profit opportunity’ for investors in natural gas than in oil, because there is more
time to respond to changes in volatility in gas than in oil. This additional response
time implies that information may not be assimilated as quickly in the natural gas
market as compared to the oil market.
It is also the case that current oil volatility depends on past volatility and not so
much on specific events or economic news. In contrast, natural gas return volatility
responds more to unanticipated events (e.g. supply interruptions, changes in reserves
and stocks, etc.), regardless of which market they originated in. Investors may be
able to take advantage of this information. For example, a major event-causing
shock will lead to an immediate increase in volatility in natural gas returns and
culminate in a (relatively) prolonged period of volatility. If prices, and thus returns,
rise in response to volatility, there may be immediate profit opportunities in natural
gas following shocks in either market. Furthermore, our findings suggest that
16
In the present case, the asset (index) can be seen as generating a continuous dividend over time.
Kolb (1997) gives a detailed explanation on how prices of European and American style (index)
options are affected by changes in volatility of the underlying index.
536 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538

volatility will begin to rise in oil returns, since oil return volatility depends on past
natural gas return volatility (as well as its own past volatility). Thus, investors may
take advantage of this pattern and anticipate a priceyreturn rise in the oil market.
The key point to this discussion is that there is a distinct pattern in the timing of
shocks and increases in volatility. Natural gas return volatility responds more quickly
to shocks and events than does oil. However, once volatility exists in either market,
then oil return volatility responds.
Our empirical findings are consistent with the description for the two markets in
Western Europe given by Soderholm (2000) (p. 162), who noted that:

In contrast to the oil market, gas markets are essentially regional. The primary reason for this
structure is the existence of a capital intensive and inflexible transportation system«.

The issue of a regional vs. global market may be important in determining the
speed to which a supplier can respond to price changes, given different industry
characteristics.17 In terms of commodity or physical markets, oil markets are part
of broader international markets, whereas natural gas markets in this context are
essentially North American. Thus, for example, it may take longer to supply natural
gas due to industry infrastructure. Furthermore, natural gas is employed relatively
more in residential use, where the service is provided through a ‘firm’ contract
rather than an ‘interruptible’ contract. This would likely result in persistent volatility
in the natural gas sector because the number of users who can respond to price
changes would be reduced.18 Note also that interruptible contracts help to suppress
volatility of the commodity concerned by transferring demand to another energy
form, otherwise prices would rise further. Finally, according to Soderholm, gas
contracts are ‘‘long-term in nature, something which tends to limit the risk for a
sudden price rise.’’ In light of our empirical finding that major event-causing shocks
lead to increases in volatility (risk) in natural gas returns, then the emergence of
contracts designed to limit the risk of sudden changes in price are a natural market
response. Furthermore, to the extent that long-term contracts introduce a degree of
price inflexibility, then we would expect the natural gas market to exhibit a relatively
greater degree of persistence than the oil market, which is confirmed by the results
reported in this paper.19 The finding of volatility transmission between the oil and
natural gas markets, and the patterns that emerge, is of practical importance to
financial market participants and may be useful in making optimal portfolio
allocation decisions.
17
According to a report by the US Department of Energy, the natural gas market exhibits properties
consistent with a ‘regional’ market, while the oil market is more ‘global’ in nature wEnergy Information
AdministrationyPerformance Profiles of Major Energy Producers, 1998x.The classification of regional
or global is mainly attributed to differences in industry infrastructure and consequently higher
transportation costs for natural gas (i.e. a pipeline is required).
18
Interruptible gas contracts are sometimes considered a major contributor to fuel oil price spikes
because of the increased demand for backup fuel when gas delivery is suspended. Under interruptible
contracts, customers may voluntarily suspend delivery if they have dual fuel capability.
19
Note, however, that there has been a considerable shortening of contract terms and, even in long-
term contracts, most transactions take place at spot prices.
 B.T. Ewing et al. / Energy Economics 24 (2002) 525–538 537

Acknowledgments

The authors would like to thank the co-editor and anonymous reviewers of Energy
Economics for their invaluable suggestions to improve this paper. We are indebted
to Jennifer Burgett of Standard & Poor Corporation for assembling the data set used
in this research.

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