Parameter variation and the components of natural gas price volatility

Matthew Brigida

Abstract

The parameters linking the demand for and supply of natural gas to natural gas prices are likely to be dynamic throughout the year and over time. However, estimating a constant coefficient for a deseasoned gas storage or weather variable implicitly assumes that market participants react identically throughout the year (and over each year) to that variable. In this analysis, we model natural gas returns as a linear function of gas storage and weather variables, and we allow the coefficients of this function to vary continuously over time. This formulation takes into account that market participants continuously try to improve their forecasts of market prices, and this likely means that they continuously change the scale of their reaction to changes in underlying variables. We also use this model to calculate conditional natural gas volatility and the proportion of volatility attributable to each factor. We find that natural gas return volatility is higher in the winter, and we show that this increase is due to weather and natural gas storage. We provide time series estimates of the changing proportion of volatility attributable to each factor, which is useful for hedging and derivatives trading in natural gas markets.