It is worth noting at this point that oil and natural gas are substitutes for each other in a number of major applications. For energy generation, for example, oil and gas are fairly readily substitutable whereas for running cars, it is not economic to substitute gas for oil. Because the major users are industry and energy generation, however, where substitutability is fairly high, the price linkage remains strong.
Cold weather will increase the demand for heating oil and natural gas, as people usually have their home temperature controlled on a thermostat in which case consumption of oil/natural gas increases automatically as the weather gets colder. This is a good opportunity for producers to increase the price. Normally, for this case, large inventories of oil and natural gas are kept in stock. However, with the inventories being as small as they are at present, there is no incentive to run them down, so prices are kept high, forcing people to either pay more or use less.
Figure 1. There is a shift in demand (D-D1) due to the cold weather and an increase in price (P-P1) due to low inventories.
It is important to understand that demand for oil and natural gas, in times of cold weather, is fairly inelastic. In order to heat a house, one of these two would be necessary, so change in price would not really affect the amount that is used that much. If you stop using these resources, then it will be difficult to heat your house.
Figure 2
As price increses (P1-P2), demand does not fall by very much. Increasing the price of a demand-inelastic product is a good way for companies to increase their revenue as the price change does not have a large effect on the demand.
Finally, an important point would be that oil prices are geopolitically volatile. Certain events can cause them to shift very easily e.g. if George Bush would suddenly declare war on Iraq, which is currently under embargo, then oil traders might fear demonstrations of sympathy for Iraq in other Arab oil producing countries. Such fears among traders would tend to drive the price of oil futures contracts higher. Fears of reduction in supply, ceteris paribus, would drive the price up.
Figure 3
As supply falls (S1-S2), price rises (P1-P2)
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