Price dynamics of crude oil and the regional ethylene markets Mansur Masih a , ⁎, Ibrahim Algahtani b , Lurion De Mello c a Department of Finance and Economics, Center of Research Excellence in Renewable Energy, King Fahd University of Petroleum and Minerals, Dhahran, Saudi Arabia b Department of Finance and Economics, King Fahd University of Petroleum and Minerals, Dhahran, Saudi Arabia c Faculty of Business and Economics, Macquarie University, Sydney, Australia abstract article info Article history: Received 1 December 2006 Received in revised form 16 March 2010 Accepted 18 March 2010 Available online 28 March 2010 Keywords: Crude oil prices Petrochemical prices Ethylene prices Price dynamics Long Run Structural Modelling (LRSM) This paper is the first attempt to investigate: (i) is the crude oil (WTI) price significantly related to the regional ethylene prices in the Naphtha intensive ethylene markets of the Far East, North West Europe, and the Mediterranean? (ii) What drives the regional ethylene prices? The paper is motivated by the recent and growing debate on the lead-lag relationship between crude oil and ethylene prices. Our findings, based on the long-run structural modelling approach of Pesaran and Shin, and subject to the limitations of the study, tend to suggest: (i) crude oil (WTI) price is cointegrated with the regional ethylene prices (ii) our within- sample error-correction model results tend to indicate that although the ethylene prices in North West Europe and the Mediterranean were weakly endogenous, the Far East ethylene price was weakly exogenous both in the short and long term. These results are consistent, during most of the period under review (2000.1–2006.4) with the surge in demand for ethylene throughout the Far East, particularly in China and South Korea. However, during the post-sample forecast period as evidenced in our variance decompositions analysis, the emergence of WTI as a leading player as well, is consistent with the recent surge in WTI price (fuelled mainly, among others, by the strong hedging activities in the WTI futures/options and refining tightness) reflecting the growing importance of input cost in determining the dynamic interactions of input and product prices. © 2010 Elsevier B.V. All rights reserved. 1. Introduction In the last decade, prices of petrochemicals have become very sensitive to movement in crude oil prices. There is also a debate among researchers and policy makers as to what factors might be driving up crude oil prices. Some blame it on geo-political events, while others point the finger to the booming economies of India, China and Korea. While some studies have tested the price dynamics of crude oil and refined petroleum products such as heating oil, gas oil, diesel and gasoline, the market dynamics of petrochemical prices and crude oil has never been tested before. Markets for petrochemicals remain small and opaque compared to oil but the trade flow concentrated between Middle East swing producers and the giant consumers of Asia is on the increase. Since the 1997 Asian financial crisis, there has been a surge in demand for petrochemicals from Asia, in particular amongst the Far East (FE) economies of China, Korea, Japan and Taiwan. The demand has also increased in other major centres like North West Europe (NWE) and the Mediterranean (MED). The increase in sensitivity of petrochem- ical prices to crude oil prices has resulted in firms taking price risk management very seriously in a bid to reduce their costs. Some analysts have stated that there is as much as an 80% correlation between crude oil and petrochemical products. In addition, there is an ongoing debate as to the drivers of crude oil prices in addition to the speculation and geopolitical tensions in the Middle East and constant supply disruptions in countries such as Nigeria and Venezuela. In addition to demand from refined petroleum products (heating oil, electricity and transportation fuels) policy makers are also interested in having a better understanding of the dynamics of crude oil prices and demand for petrochemicals (mainly olefins and aromatics), which are key feedstocks in the production of final products such as plastics, polymers, nylon and rubber. There are two issues that need testing in the petrochemical and crude oil chemistry; firstly we need to model the dynamics between crude oil and petrochemicals which has been largely ignored in the literature (excepting some petrochemical industry consultancy reports). Secondly, the transparency and availability of petrochemical prices gives us an opportunity to assess the dynamics between major petrochemical markets by using ethylene, which is the barometer for the petrochemical market. 1 Our research is in line with studies that try to capture price dynamics between various commodity spot prices and in particular major between crude oil barometers like the United States West Texas Intermediate (WTI), U.K North Sea Brent (Brent) Energy Economics 32 (2010) 1435–1444 ⁎ Corresponding author. Tel.: + 966 3 8602135; fax: + 966 3 8602585. E-mail address: masih@kfupm.edu.sa (M. Masih). 1 To our knowledge the most accurate and independent petrochemical prices are reported by organisations such as www.icis.com and www.platts.com. 0140-9883/$ – see front matter © 2010 Elsevier B.V. All rights reserved. doi:10.1016/j.eneco.2010.03.009 Contents lists available at ScienceDirect Energy Economics journal homepage: www.elsevier.com/locate/eneco