Gas forward curve

Price discovery in gas is not as transparent as in the oil market. The transport and
storage capabilities of the gas market is relatively inflexible compared to the oil
market. The market is also more regional7 than the oil market, with international
trade being restricted by pipeline costs and LNG (liquefied natural gas) processing
and transport costs.
The US gas trading market (although probably the most developed in the world) is
much more fragmented than in the oil market with a large number of small producers,
particularly at the production end. Given the inability to hedge through vertical
integration or diversity this has resulted in a significant demand for risk management
products. The market after the deregulation in the 1980s and early 1990s has been
characterized by the development of a very significant short-term market. This sets
prices for a thirty-day period during what is known as ‘bid week’.8 The prices
generated during this ‘bid week’ create an important benchmark9 against which
much of the trading market is based.
The futures contracts in gas have been designed to correspond with the timing of
bid week, the largest and most developed contract being known as Henry Hub. This
has been quoted on NYMEX since 1990, supports a strong options market and
extends out three years on a relatively liquid basis. Basis relationships between
Henry Hub and the major gas-consuming regions within the USA are well established
and, in the short term, fairly stable. The OTC market supports most basis locations
and a reasonable option market can be found for standard products. It is worth
noting that, credit aside, in energy the value of the futures market and the OTC
forward market is the same, albeit the delivery mechanisms are different. This is
true because there is no direct correlation to interest rates and the EFP (Exchange
for Physical) option imbedded in the futures contract.
In gas, storage costs play a critical role in determining the shape of the forward
curve. A variety of storage is employed from line pack (literally packing more gas
molecules into the pipe) to salt caverns and reservoirs (gas can be injected and
extracted with limited losses) and the pricing and flexibility of the different storage
options varies significantly.
As a general rule, the gas market stores (injects) during seven or eight ‘summer’
months and extracts during the winter months. Significant short-run price movements
occur when this swing usage is out of balance. In these circumstances gas
traders will spend much of the time trying to predict storage usage against their
demand estimations it order to determine what type of storage will be used during
the peak season and thus help set the future marginal price.
Like the oil market, the gas markets exhibit mean reversion, and are subject to
occasional jumps due to particular ‘events’ such as hurricanes shutting down
supplies. But most importantly, despite this storage, gas remains significantly more
seasonal in nature than most of the oil market.

Basis trading from Henry Hub plays a vital part in the market with differentials to
the major consumption zones being actively traded in the OTC market. These basis
prices are less stable than those seen in the oil market given the more constrained
transport infrastructure and volatility in demand. As a result, the monitoring of these
basis relationships under normal and extreme conditions becomes critical.
Risk managers should be very wary of basis traders or regional traders marking
their books against a contract in a different region such as Henry Hub who are
seen to have large ‘book’ profits based on future positions. There have been a
number of instances where such regional traders have had their positions wiped
out overnight when the correlations have broken down under extreme market conditions.
In other words, you need to ensure that the higher volatility or ‘spike potential’
in less liquid regional markets compared to a large liquid hub has been reflected
in the pricing.
Historical ‘basis’ positions may also fundamentally change as the pipeline positions
change. For instance, the increasing infrastructure to bring Canadian gas to the
Chicago and North US markets could significantly change the traditional basis
‘premium’ seen in these markets compared to Henry Hub.
While most trades up to three years are transacted as forward or future positions
an active swap market also exists, particularly for longer-term deals where the
counter-parties do not want to take on the potential risks associated with physical
delivery. These index trades are generally against the published Inside FERC Gas
Market Report Indices although Gas Daily and other publications are also used
regularly. It is necessary to be aware that indices at less liquid points may not be
based on actual transaction prices at all times, but may be based on a more
informal survey of where players think the market is. This may lead to indices being
unrepresentative of the true market. 531