Drill-Bit Parity: Supply-Side Links in Oil and Gas Markets

Abstract

Previous analyses of relationships between crude oil and natural gas markets focused primarily on demand-side connections. We provide a model and empirical evidence of important supply-side connections. First, crude oil and natural gas production require common inputs: drilling rigs, well completion services, and specialized labor. Competition for these inputs creates a cost-spillover channel through which a price shock for one commodity reduces supply of the other commodity. Second, crude oil wells produce associated gas, while natural gas wells often produce associated liquid hydrocarbons. This creates an associated-commodity channel through which a price shock for one commodity will increase supply of the other. Which effect dominates depends on the characteristics of the producing region. We test the model using well-level data from five large oil and gas producing basins in Texas and Oklahoma. We find substantial evidence across all five basins of a cost-spillover channel between natural gas prices and oil drilling, but mixed evidence of an associated-commodity channel between oil prices and natural gas drilling. Finally, we discuss the implications of these supply-side connections for energy policy.

Keywords: Energy, Petroleum, Crude oil, Natural gas

JEL Classification: D72, F18, F59, Q56