Journal of Business & Economics Research November 2006 Volume 4, Number 11

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1 Forecasing Perormance O Naural Gas Fuures Marke: An Assessmen O Recen Daa Salah Abosedra, Lebanese American Universiy, Lebanon. Khaled Elkhal, Universiy o Souhern Indiana Faisal Al-Khaeeb, Unied Arab Emiraes Universiy, UAE ABSTRACT Naural gas has assumed increasing imporance in he global energy marke. This sudy evaluaes he orecasing perormance o uures s o naural gas in he large marke o he U.S. a various ime horizons. The resuls indicae ha uures s are unbiased predicors a he 1-, 6-, and 12- monh horizons, bu no a he 3- and 9- monh horizons. The resuls urher sugges ha uures s o naural gas, alhough biased a some inervals, signiicanly ouperorm naïve orecass in predicing uure movemens o spo s. In addiion, he inormaion conen o he 1-monh ahead uures proves especially useul as a orecasing device. Policy implicaions are also discussed. INTRODUCTION W hile several sudies examine he eiciency o crude oil uures markes in he U.S. and oher consuming naions 1, research on he eiciency o naural gas uures marke in he U.S. and elsewhere is relaively scan. This appears surprising given he increasing imporance o naural gas uures markes since is incepion in Naural gas is a criical world commodiy whose world consumpion is expeced o grow by 70% in he nex wo decades (Inernaional Energy Oulook, 2004). Is expeced growh rae o more han 2.2% annually unil 2025 is signiicanly higher han ha o oil (1.9%) and coal (1.6%). The volume o uures naural gas conracs raded on he New York Mercanile Exchange (NYMEX) has more han doubled beween 1999 and In addiion, he exreme spikes in naural gas s during , and he signiican increase since hen, have made orecasing uure s a necessiy or boh producers and users o naural gas. This sudy evaluaes wheher uures s o U.S. naural gas provide unbiased and accurae orecass o subsequen spo s as is implied by marke eiciency. In paricular, we examine he orecasing perormance o he 1-, 3-, 6-, 9-, and 12-monh ahead uures s o naural gas rom November 1993 o November We invesigae he predicive inormaion conen o uures s using comparable orecass rom a naive orecasing model. The res o he paper is organized as ollows. Secion 2 provides a brie accoun o he relevan lieraure. Secion 3 describes he daa and he esing procedures. Secion 4 discusses he empirical resuls. Secion 5 concludes. PRIOR RESEARCH The issue o uures markes eiciency has received considerable aenion in he lieraure since eicien uures markes provide invesors wih an imporan vehicle or risk reducion. Paricipans in he spo marke can hedge unexpeced changes in spo s by paricipaing simulaneously in he uures markes. This requires hedgers o calculae he opimal hedge raio and sell an amoun o uures conracs equal o his raio or each spo posiion 1 See, or example, Quan (1992) and Gulen (1998). 65

2 hey held. Early sudies like Myers and Thompson (1989) calculae he opimal hedge raio rom regressing he reurns o holding spo on he reurns o holding he hedging insrumens. Algebraically: s s 1 ( F F 1) e (1) where, s = spo, and F = o hedging insrumen. Invesors can reduce risk by acquiring an opposie uures posiion relaive o heir spo posiion. Speculaors are oen ineresed in he eiciency o uures markes since hey capialize on arbirage opporuniies whenever shor-run posiions depar rom long-run equilibrium condiions. Clearly, a suicien dierence beween uures and spo s is needed considering he associaed cos o carry. Herber (1993) examines he relaion beween he selemen o naural gas (NG) on he uures conrac and he average spo a he Henry Hub or he same delivery monh. His evidence or he hen young uures markes suggess possible marke ineiciency. However, Walls (1995) repors conradicory resuls ha are supporive o marke eiciency. A more recen sudy by Murry and Zhu (2002) examines he eiciency o U.S. cash and uures naural gas markes in relaion o he inroducion in November 1999 o Enron Online (EOL) aciliaed gas rading sysem. From November 1999 unil Enron ailed in lae 2001, rading volume winessed subsanial growh, reaching more han $550 billion in he irs hal o 2001 compared o only $50 billion during he irs hal o However, Murry and Zhu ind no evidence or eiciency improvemen associaed wih he EOL sysem, alhough hey documen signiican increase in marke volailiy a he ime o Enron collapse. DATA AND THE TESTING MODEL We use monhly spo and uures s rom November 1993 o November Spo s represen closing s observed in he las rading day o he monh, while uures s represen -monh ahead conracs observed a he close o he las rading day o he monh wih = 1, 3, 6, 9, and 12. We obain Henry Hub spo s rom he Energy Inormaion Adminisraion and collec daa on uures s rom he New York Mercanile Exchange (NYME). Examinaion o inormaion eiciency in he NG uures marke is based on sudying he shor-erm relaionship beween spo and uures s. Some prior sudies, e.g., Walls (1995), es marke eiciency by exploring he long-run dynamics o he spo and uures relaionship in he conex o coinegraion and errorcorrecion models, hough Brenner and Kroner (1995) argue ha coinegraion beween spo and uures s requires speciic condiions ha are unlikely o be saisied in commodiy markes. Le S and PF be he logarihm o he spo in monh, and he logarihm o he -monh ahead uures made in monh, respecively. Le PN +, be naive orecass o NG s or he dieren ime horizons where sands or he corresponding monhly horizon. These orecass are simply he logarihms o NG spo s observed beore he las rading day o he corresponding monh. Such s could serve as naïve predicors o he uure direcion o naural gas spo s since hey represen he mos recenly known inormaion on he las rading day o he monh when uures s are deermined. We compare he orecasing perormance o uures s relaive o hose obained rom a naïve (and hence mos likely ineicien) orecasing model. Fuures s are deemed ineicien i hey are ouperormed by naïve orecass. We begin by esing unbaisedness o uures and naïve s since i is a prerequisie or esing orecasing accuracy. To do ha, we regress he -monh ahead spo a ime, denoed by S, on he corresponding - monh ahead predicor o he spo, also made a ime, and denoed by P. Algebraically: S S a a1( P S 1) v 1 0 (2) 66

3 where = 1, 3, 6, 9, and 12 and v is a whie noise error erm. Noe ha he predicor variable P could eiher be he naïve or he uures. We subrac he erm S -1 rom boh sides o he above equaion o ensure saionariy o he wo variables (Fair and Shiller, 1990). Unbiasedness requires ha a 0 and a 1 in equaion (2) above. 0 1 The orecasing accuracy o uures s esimaing he ollowing equaion: PF versus naïve s PN can be esed hrough S S ) 1 b0 b1 ( PF S 1) b2 ( PN S 1 v (3) where = 1, 3, 6, 9, and 12 and v is a whie noise error erm. I b1 is insigniican bu b2 is signiican, hen naïve s ouperorm uures s or predicing subsequen movemens in spo s, perhaps implying ha he NG uures marke is ineicien. However, i b 1 is signiican while b2 is no, hen uures s have more predicive inormaion han naïve orecass and he NG uures marke is considered eicien. The wo coeiciens may boh prove insigniican (signiican) in which case uures s and naïve orecass have lile (suicien) power or predicing subsequen spo s. EMPIRICAL RESULTS Beore proceeding urher, wo remarks are in order peraining o he naure o spo and uures s. Firs, as shown in Table 1, spo s display more volailiy (measured by sandard deviaion) han do uures s across all horizons. This suggess ha invesors in he uures marke view heir counerpars in he spo marke as merely noise raders. Thereore, hey end o be more conservaive in heir rading approach and do no ake shocks in he spo marke very seriously. Second, visual inspecion o uures and spo NG s o alernaive conracs over he esimaion period (no shown here o save space) suggess ha he shorer is he mauriy o he uures conrac, he beer is he orecasing accuracy. The 1- monh ahead uures s, observed a ime, move paricularly closer o acual spo s observed a ime +1. Prior o esing orecas unbiasedness on he basis o equaion (2), we check he saionariy requiremen o spo and uures s using he Weighed Symmeric es, he Augmened Dickey-Fuller, and he Phillip-Perron ess. The use o dieren uni-roo ess is pruden o ensure ha inerences regarding he imporan issue o daa nonsaionariy are no driven by he paricular es used. The resuls (available upon reques) indicae ha uures and spo s are non-saionary in levels bu hey become saionary i convered o irs dierences. Thus, we should subrac he erm S -1 rom boh sides o equaions (2) and (3) o ensure saionariy o he variables. To ensure saisically consisen esimaes, we use he AR1 procedure o eliminae any possible irs-order auocorrelaion in he esimaed errors. Esimaed resuls repored in Table 2 or equaions (1) and (2) sugges ha uures s are unbiased predicors o subsequen spo s a 1-, 6-, and 12- monh horizons. However, uures s appear biased predicors a he 3-and 9- monh horizons since he coeicien esimaes are signiicanly dieren rom uniy. Perhaps more imporanly, uures s consisenly ouperorm naïve orecass in erms o orecasing accuracy in all orecasing horizons since he coeicien esimaes or uures s are signiicanly dieren rom zero whereas he coeicien esimaes or naïve s are no. Furher suppor or his verdic comes rom he ac ha he adjused R- square is consisenly higher or he uures equaions han or he naïve equaions. To shed urher ligh on he above comparison, we compue Theil s inequaliy coeicien (U) o evaluae he useulness o uures s over naïve orecass or predicing subsequen movemens in NG spo s. Theil s inequaliy coeicien is a sandardized roo-mean-square-error (RMSE) which ranges beween 0 and 1. Smaller values sugges good predicions whereas larger values sugges poor predicions. Table 3 repors resuls rom Theil s comparisons. As can be seen rom he able, he U coeiciens or uures s are consisenly lower han hose 67

4 rom naïve orecass a every inerval level, including he 12-monh ahead horizon. This implies ha uures s serve as a beer orecasing ool han does he naïve model across all ime horizons. Moreover, he coeicien U is he lowes or he 1-monh ahead orecas and i is he highes or he 12-monh ahead orecas, conirming our previous conjecure ha orecass o shor-erm conracs seem more accurae han hose o longer erm horizons. CONCLUSION This sudy invesigaes wheher uures s o U.S. naural gas are unbiased and eicien predicors o subsequen spo s a various monhly horizons. Such an examinaion should be useul given he proound economic and inancial implicaions o sharp movemens in energy s in recen years. I uures s o naural gas accoun well or subsequen movemens o NG spo s, hen policy makers and regulaors can benei rom he inormaional conen o uures s. Oherwise, i is advisable or policy makers and regulaors o seek alernaive means o orecas spo s o NG in he uure. Local gas uiliies, aemping o sabilize NG s in he uure, have hedged uncerainy by using orward conracs. Since spo s o NG have been excepionally volaile since 2000, heavy reliance on orward conracs seems oo risky and he use o uures NG conracs o hedge pricing risk is expeced o increase. Compared o orward conracs, uures conracs have he advanages o lower risk and lower ransacion coss. Our resuls sugges ha uures s are unbiased predicors or he 1-, 6-, and 12- monh horizons, bu no or he 3- and 9- monh horizons. The evidence also reveals ha, while biased a cerain horizons, uures s ouperorm corresponding naïve orecass across all orecasing horizons. In addiion, resuls rom Theil s inequaliy coeiciens sugges ha he 1 monh-ahead conracs provide he bes predicor o uure spo s. Alhough he evidence we ind over he sample period rom November 1993 o November 2004 suppors he use o uures NG s as a reliable orecasing device, we cauion ha uncerainy in he uure demand due or example o volaile weaher condiions and poliical insabiliy in major NG producers in he Middle Eas and elsewhere could adversely impac he orecasing perormance o uures NG s. Thereore, policy makers and public uiliies should no rely exclusively on any one device, including uures s, o orecas uure direcions o NG s. REFERENCES 1. Brenner, R.J. and Kroner, K.F., Arbirage, Coinegraion, and Tesing he Unbiasedness Hypohesis in Financial Markes Journal o Financial and Quaniaive Analysis 30: Fair, R.C. and Shiller, R.J., Comparing Inormaion in Forecass rom Economeric Models. American Economic Review 71: Gulen, S.G., Eiciency in he Crude Oil Fuures Marke. Journal o Energy Finance and Developmen 3: Herber, J., The Relaion o Monhly Spo o Fuures Prices or Naural Gas. Energy 18: Myers, R.J. and S.R. Thompson, Generalized Opimal Hedge Raio Esimaion. American Journal o Agriculural Economics 71: Murry, D. and Zhu, Z., ENRONONLine And Eiciency in he U.S. Naural gas marke. Paper presened a he annual meeing o he inernaional associaion o energy economiss, Vancouver, B.C., Ocober Quan, J., Two-Sep Tesing Procedure or Price Discovery Role o Fuures Prices. The Journal o Fuures Markes 12: Walls, W.D., An Economeric Analysis o he Marke or Naural Gas Fuures. Energy Journal 16:

5 Table 1: Descripive Saisics o Monhly Naural Gas Spo and Fuures Prices (November 1993 November 2004) S F1 F3 F6 F9 F12 Mean Sd. Dev Minimum Maximum Sum Variance Skewness Kurosis Noes: S is spo ; F1 is one-monh ahead uures ; F3 is hree-monh ahead uures ; F6 is six-monh ahead uures ; F9 is nine-monh ahead uures ; and F12 is welve-monh ahead uures. Table 2: Tess o Unbiasedness and Forecasing Perormance o Fuures Prices Versus Naïve Forecass Dependen Variable Consan Fuures Naive RHO DW Adj. R (-.3057) (1.4878) (.89519) monh ahead spo (.2715) (0.4430) (-.9405) ** (-.2198) (2.9337) (1.4703) (-.3563) **.6541** (.1412) (2.9991) (9.9419) monh ahead spo **.6357** (.4647) (5.1804) (9.3919) ** ** (.0722) (5.6624) ( ) ( ) ** (.4053) (1.4945) ( ) monh ahead spo **.7793** (.5125) (5.1468) ( ) ** ** (.3767) (6.4627) ( ) ( ) **.8396** (.4149) (4.0540) ( ) monh ahead spo **.8487** (.4188) (7.6346) ( ) ** ** (1.0073) (4.5277) (-.6763) ( ) ** (.9437) (0.6029) ( ) monh ahead spo **.8299** (.8163) (5.1827) ( ) ** **.8183** (.9358) (7.7746) ( ) ( ) Noes: The independen variable Fuures is he -monh ahead uures corresponding o he -monh ahead spo. RHO is he serial correlaion coeicien and DW is he Durbin-Wason saisic. The igures in parenheses are -saisics. An ** indicaes saisical signiicance a he 5% level. Table 3: Theil s Inequaliy Coeiciens or Comparing he Forecasing Accuracy o Fuures Prices versus Naïve Forecasing Prices 1-monh 3-monh 6-monh 9-monh 12-monh Fuures Prices Naïve Prices Noes: Theil s inequaliy coeicien ranges beween 0 and 1. A value close o zero indicaes accurae orecass whereas a value close o one indicaes inaccurae orecass. 69

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