Gas Trading  Efficient Business or the 'Wild West'?

As printed in the March, 2002 PetroGrowth Advisors Newsletter

The recent Enron bankruptcy and the preceding California energy crisis have highlighted a variety of business and industry practices which deserve review and additional scrutiny. The following article attempts to highlight concerns shared by many energy industry participants regarding one such issue: the trading of natural gas and how it potentially creates volatility in the market.

 

Increased Trading Volumes

 

The introduction of the NYMEX Henry Hub natural gas futures contract on April 3, 1990, was a milestone event in the transition to an open, competitive market for the gas commodity and its transportation. In the ensuing decade, trading in futures, options, and other 'derivatives' has matured into a vital feature of the U.S. gas marketplace. Total daily volume now exceeds 70,000 contracts on active trading days, which translates into a market of roughly $1.75 billion in a given day.

 

Within this trading environment, gas marketers dominate. At least 80% of all gas supplies produced and consumed in North America passed through the ownership of gas traders at some point during 2000. In particular, major diversified energy marketers, many of which had been expanded by mergers, handled the bulk of transactions in 2000. Obviously, Enron was an example of this concentrated activity.

 

The impact of the increased trading activity is demonstrated when compared to end-use consumption. From 1994 to 1998, traded gas volumes more than doubled, while total consumption rose by only 3%.

 

Everyone buying a NYMEX gas futures contract is technically arranging to have gas delivered to a marketing hub in Louisiana. Only a limited amount of gas can physically be moved through the hub, but because gas on the futures market usually is not delivered, this typically is not a problem.

 

Total reported physical gas sales volumes for all 158 gas marketers reporting positive sales in 1998 was 67.4 trillion cubic feet, representing an increase from 59.7 trillion cubic feet in 1997. Ultimate natural gas consumption in the United States and Canada during 1998 was 24.9 trillion cubic feet, according to the U.S. Energy Information Administration and Statistics. Thus, at least 2.7 thousand cubic feet of gas changed ownership in physical markets for every thousand cubic feet consumed. This creates a huge leveraging effect to the trading of natural gas.

 

Convergence of the Gas and Power Worlds

 

The electricity and natural gas industries are related in many ways. Today, natural gas is used to generate electricity, especially during periods of peak demand, and it is the preferred source of energy for most new capacity. Both industries are also 'network' industries in which energy sources are connected to energy users through a sometimes complicated maze of transmission and distribution lines. In the future, the two industries will not only be related but also interrelated by new institutions such as futures and spot contract markets. The degree to which natural gas will be a preferred energy source for peak electricity generating needs in the near future, or lose market share to electricity in the residential, commercial, and industrial sectors will be determined largely by these new institutions as well as the new business practices.

 

Although natural gas is used extensively for peaking service in electricity generation, gas contract terms are not consistent with electrical power needs.  Hence, the amount of gas used for power generation is less than it could be only because it is much more timely and much easier to trade power than to purchase gas to generate power. At times, traded power is used instead of natural gas to satisfy a need even when generation from natural gas would have been the preferred choice.

 

This supply/demand issue is illustrated by the resulting prices. Peak electricity prices can often be three times as great as non-peak prices, and daily peak prices can increase several-fold over several days. Such large price fluctuations result in corresponding variations in the need to dispatch gas-fired generation because of the shifting relative economics. Consequently, rigidities in the flexible use of natural gas for power generation can cause significant lost opportunities for the industry. The continued opening up of the electricity industry and the increased availability of timely, reliable price information will provide a growing incentive for gas suppliers to shorten contract terms and increase the flexibility of scheduling practices to capture opportunities for expanded sales to the general sector.

 

However, shorter contracts can also result in negative consequences such as volatility in pricing and problems with 'matching' the long term needs of some.

 

The price spread between electricity and natural gas markets with good information and the many diverse participants is likely, on average, to be relatively constant. Exceptions will arise in periods with unexpected and significant shifts in the demand and the supply of the commodities. At such times, either the price of electricity or the price of natural gas will change significantly as demand for or supply of either fuel reacts. For example, if the electricity price increases significantly relative to that of natural gas because of a significant increase in power demand, there will be a tendency to purchase additional gas for the generation of electric power, thus raising the price of natural gas also. These changes in supply and demand will promote efficient increases in trade at critical times, as long as sufficient capacity is available to produce and deliver energy.

 

Resulting Volatility

 

Price volatility is commonly higher for electricity and natural gas than for other commodities. Most commodities exhibit price volatility of less than 20%, whereas the average price volatility for natural gas and electricity generally exceeds 40%.

 

The decline in volatility of natural gas prices in the Spring could reflect the simple fact that natural gas prices are influenced greatly by temperature, the variability of which is at its lowest in the Spring. Natural gas, much more than electricity, is used for space heating which is temperature sensitive use of energy. On the other hand, electricity price variability is influenced not only by temperature variability, but also by unplanned outages of generators and a greater number of transmission problems. In addition, the inability to store electrical energy means that buffer stocks are not available to respond to unexpected contingencies throughout the year.

 

The trading of electricity and natural gas is not nearly as synchronized as it could be. The amount of trading in electricity and natural gas needs to enable these markets to take advantage of arbitrage opportunities is less than it could be, limiting the liquidity of both markets.

 

The terms of the shortest-term natural gas contracts tend to be longer than the terms of the shortest-term electricity contracts.  When the terms of gas contracts become shorter, when deliverability and flexibility improve, and when nominations for gas and electricity are better synchronized within days, a greater number of trades can be completed.  As a result, the level of price volatility could be reduced and the changes of regular price convergence could be increased.