Convergence of European spot market prices for natural gas? A real-time analysis of market integration using the Kalman Filter

Abstract

This letter provides a textbook example of an econometric analysis of the integration between two commodity markets and the subsequent price convergence or absence thereof. Price relations between spot markets are analysed for natural gas in Europe. The European market for natural gas is currently undergoing a liberalization process with the aim of creating a single, unified market. Time-varying coefficient estimation models are used, applying the Kalman filter to test whether price convergence between different locations is really taking place. The results reveal that the construction of a pipeline between the UK and Zeebrugge (Belgium) has led to almost perfect price convergence between these locations in the time period under consideration; on the other hand, liberalization on the European continent does not seem to be working so far.

Notes

¹ The law of one price states that in competitive markets free of transportation costs and official barriers to trade, identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency (Krugman and Obstfeld, 2003).

² During the period under observation, natural gas mainly flowed from the UK to Continental Europe (1193 days) and was only interrupted for 9 days leaving 359 days of natural gas flowing in reverse direction.

³ For a formal description see Harvey (1989) and Meinhold and Singpurwalla (1983).