Sample News Story
Canadian Futures Break Brick Wall in US Gas
28/11/1996
Futures trading in Canadian gas-based contracts on the New York Mercantile Exchange (Nymex) has come none too soon for domestic gas trade in the US. The hope is that the new Canadian natural gas futures contract, launched on Nymex on September 27 – just before the start of the new US “gas year” on October 1 – will offer traders a better hedging tool against price risk in North American gas markets.
Hooray, Henry For its part, Nymex hopes to repeat the once-in-a-decade success of its heavily-traded gas futures contract based on gas delivered at Texaco’s Henry Hub in Erath, Lousiana. Introduced in April 1990, Henry Hub went on to become the new contract with the fastest growth rate since the last big one – the crude oil futures launched in the 1980s. Indeed, the success of energy futures trading now appears to have crushed, once and for all, the myth that futures markets somehow apply only to agricultural commodities, metals or monetary instruments.
Never enough The arrival of Henry Hub futures, however, also brought problems for some gas traders in the US and Canada as they tried to protect themselves against the price risks attached to spot trades by acquiring futures. Until now, the only robust gas futures market available to them was for gas priced for delivery in Louisiana – regardless of where those traders were actually operating, and irrespective of whether delivery of gas from Louisiana was relevant to them.
California dream This shortcoming has made a significant difference to traders based in western US gas markets, above all those in the biggest market of them all in that part of the world, California. On Nymex, until September 27, it was Henry Hub futures or nothing; now there is an alternative – futures priced for delivery in Alberta, the main gas-producing province in western Canada (as well as the country as a whole). Alberta also happens already to sell quite a lot of gas to western US markets such as California.
Diverge This would probably not have mattered very much had North American gas prices maintained some degree of uniformity in movement or volatiliy right across the country during the course of this decade. This has not been the case in recent years, primarily because of two factors which combined to produce increasing divergence in the regional pattern of gas prices in the US.
Look east In the first place, most US gas pipelines were built to transport gas from the Texas/Louisiana Gulf Coast and Mid-continental gas-producing regions eastwards to Mid-western and Atlantic gas markets. In contrast, capacity to deliver gas produced in the west to markets in the east has been (and remains) limited.
Go west Secondly, gas production in the west is contributing an increasingly important proportion of gas output in North America as a whole. Gas produced in the west – which we define as Alberta, British Columbia, Saskatchewan and North West Territories in Canada, plus California, Colorado, Montana, New Mexico, Utah and Wyoming in the US – accounted for 32% of all the gas produced in North America last year, compared with 26% in 1985 and 21% in 1975 (see chart below).
Much more Forecasts from organisations such as the Energy Information Administration (EIA) at the US Department of Energy (DoE), the Canadian Energy Research Institute and Canada’s National Energy Board (NEB) indicate that this figure could hit 40% in the next several decades.
Fill it up With growing output on the one hand, and the fact that most American pipelines still run from the middle of the continent towards the east, a glut of gas has evolved west of the Mississippi, especially in Alberta and the US Rocky Mountains. Existing pipelines have become more and more clogged at their western receipt points and along west-to-east routes. Despite the unremitting east-to-west shift in North American gas production, pipeline expansions have not come through rapidly enough to allow eastern outlets to tap into western production and relieve the glut there.
Every which way The result has been increasing west-to-east price volatility as western gas finds pipeline capacity available one day but not the next, with 200% gyrations in some basis markets earlier this year. While demand pushed up prices for gas with pipeline capacity to transport it eastwards, in contrast the glut in the west kept gas prices there flat and lifeless. The limitations on capacity to transport western gas to the major
US and Eastern Canadian markets came to the fore during the harsh conditions of the 1995-96 winter.
Basis madness Gas price trends in the severe climatic conditions of last winter illustrated just how bifurcated North American gas markets have grown. In an industry addicted to speaking its own jargon regardless of the consequences, the term “basis madness” evolved to describe what happened to the market. An invisible but very real north-south barrier, which we have dubbed the Brick Wall, in effect separated Western gas markets from Eastern markets (see map below). As the winter ground on, basis – defined as the local spot gas price minus the spot price at Henry Hub – stood stood in March 1996 at:
u all basis to the west of this Brick Wall was quite negative and gas markets were deeply isolated from Henry Hub trading, illiquid and stranded; and
u all basis to the east of the Wall, however, was positive, and this gas was more costly than inflated Henry Hub prices.
Well down For example, March 1996 gas in Alberta (measured at the AECo-C Hub in Alberta, where Canadian gas futures gas can now be delivered) cost $1.94/MMBtu less than gas at Henry Hub. In American gas industry-speak, the terminology for this is that AECo-C basis was “minus $1.94”. Likewise, basis at Opal, Wyoming, was “minus $1.79”, and even Houston basis was “minus $1.20” – even though Houston is less than 250 miles from Henry Hub. Normally, Opal and Houston bases stand at about “minus $0.65” and “minus $0.10”, respectively.
On the up In contrast, on the other side of the Brick Wall, Appalachia basis was “plus $1.70” (per MMBtu) while Chicago and New York were “plus $0.21” and “plus $0.44”, respectively. Interestingly, the relatively low basis in northern US cities was clearly the result of Canadian gas deliveries via the recently-expanded TransCanada and Northern Border pipelines. Even at distances of more than 2,000 miles, Western Canadian gas influenced northern tier American gas prices by more than $1.00/MMBtu last winter.
Cool it By September 1996, things had settled down a bit, as indicated by a rather less dramatically different range of basis figures (see chart above). West of the now-crumbled Brick Wall, Opal and Houston basis per MMBtu stood at “minus $0.64” and “minus $0.11”, respectively. In the east, Appalachian and New York basis were “plus $0.10” and “plus $0.21”, respectively. Nonetheless, Alberta gas remained approximately $1.00 per MMBtu below Nymex Henry Hub prices ($0.96 in September 1996).
Volatility The problem for Alberta gas buyers and sellers has been that basis never settled down to a reasonable level or pattern which could be realistically hedged on Nymex. Unlike prices in most other North American gas markets, Alberta prices have remained out of kilter with Henry Hub futures and cash prices since 1990. As a consequence, basis risk in Alberta has, therefore, remained unacceptably high, a reality that has not helped sales.
New tool Canadian gas futures trading on Nymex should now provide a mechanism for hedging price risks of Alberta gas independently of gas markets in the US Gulf Coast producing region, a capability that has been sorely needed up to now. In addition, extra pipeline capacity to transport gas from the west to the east would help bring down the Brick Wall for good.
Wobbly However, although the Canadian gas futures market will provide a better way to manage certain price risks in the future, it should not be assumed that it will prevent “basis madness” from ever happening again. Price volatility will continue to characterize American gas markets for the foreseeable future.
Watch this In the short term, the industry is closely monitoring gas storage to help prepare for the coming winter. Indeed, gas storage was depleted in 1996 to a far larger degree than in previous winters (see chart, above) although fill rates through October 1996 have been encouraging, and there looks to be an adequate level going into this winter.
New deals However, during the next ten years, only major additions to west-to-east gas pipeline capacity in North America will help minimize recurrences of the Brick Wall, or ease any tendency towards a renewed bout of “basis madness”. Some important possibilities are in the works:
u expansions of the Colorado Interstate, Wyoming Interstate and Trailblazer pipelines were approved in September 1996 by the Federal Energy Regulatory Commission (FERC), which will increase access of Rocky Mountain gas resources to Chicago and other US midwestern markets;
u a consortium of Canadian producing companies has proposed construction of the 1,900-mile Alliance pipeline project to carry 1.25 Bcfd of gas from western producing areas near Fort St John, British Columbia, to Chicago at an estimated cost of some $2.6 billion (US dollars);
u among other possible US capacity expansion projects, KN Energy has proposed its Pony Express line from Wyoming to Missouri, El Paso has added to its west-to-east capacity, and there are proposals to boost Koch Gateway in Texas; and
u several other major new pipelines from Alberta to US markets are possible, including the proposed National Fuel-TransCanada expansion aimed at increasing Alberta gas shipments to New York and the Palliser pipeline through Saskatchewan to augment capacity to the US midwest.
Better basis All these projects would surely improve gas supply deliveries and pipeline service, reliability and so on to midwestern and Atlantic markets. By easing Western gas supply constraints, they should also reduce Alberta gas supply price risks, and make the basis between gas markets in Alberta and Henry Hub more consistent.
Power to the fore Eventually, the rise of electric power marketing in America will also tend to reduce weather-related basis risks in North America. By serving an expanding array of customers with inter-fuel substitution capabilities, power marketers will be able to “end-run” gas transportation constraints. Today’s wholesale competitive electricity marketing industry in the US is in its infancy (see Gas Matters, August 1996, page 1) and remains highly concentrated. Nonetheless, power marketers serve an expanding market nationwide, and they now number 153 companies, the majority of them affiliated with gas marketers.
Growing share Western gas holds a steadily rising share of total North American gas production, but west-to-east pipeline capacity continues to be severely constrained during part of the year. Thus, as weather-driven gas and power demands fluctuate, market operators will naturally react, at least on short-term gas prices; upheavals in basis of the sort experienced last winter will probably recur.
Old hat Natural gas, pipeline capacity and storage capacity are all increasingly regarded and traded as commodities in North America. Occasional basis upsets are the price of a liberalised gas market. We believe that the alternative – governmental gas price controls – would be worse. On that front, both the US and Canada have certainly “been there, done that”.
Prospects Canadian gas futures trading on Nymex will grow as gas marketers seek ways of better managing the price risks inherent in the deepening free market. Nonetheless, only major additions to pipeline capacity will resolve the growing imbalance in North American gas markets.
This contribution was written by Benjamin Schlesinger, president, Benjamin Schlesinger and Associates, Inc., Bethesda, Maryland, USA, whom we thank for the analysis and graphics as well.