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Gas Price Behavior: Gauging Links Between Hubs and Markets

Fortnightly Magazine - April 1 1996

Price disparities make hedging difficult (em all the more since futures close before bid week ends. Even so,

a strategy helps.

Gas markets in the United States are complicated, dynamic, and evolving. They offer significant commercial opportunities for some companies, commercial hazards for others.

Many companies find it difficult to estimate the price they will receive for gas the next year, month, week, or day. Even with two futures markets, companies still find it difficult or expensive to hedge price risk completely.

Today, understanding price behavior and knowing how to respond has commercial value. Moreover, in an evolving energy marketplace accessible to an increasing number of companies, market shares are sliced by competitive strategies supported by almost constant involvement in market activity.

Cash vs. Futures Prices

The most important relationship for a futures contract market probably lies in the expected near equality of futures and spot prices for the same delivery period at the close of trading of the futures market. If these two prices are not equal, trade between markets will soon bring them back into alignment. Traders, for example, will buy the commodity on the spot market and then sell through a futures contract when the futures price exceeds the spot price by more than the transaction cost required to complete the trade. However, gains from such risk-free trades accrue only to companies that constantly track the market.

Markets for natural gas are different from most other commodity markets. Spot markets for guaranteed deliveries during a delivery month stay open after the futures market closes. This feature can create hedging problems for a company that uses the cash and futures market; it will close out its futures position prior to completing the cash deal.

A trader obtains a perfect hedge only if the futures price equals the cash price when the cash contract is completed. When prices are different, the trader may incur an additional cost from having used the futures market. For example, if the futures price lies below the cash price, a buyer that has taken a position in the futures market will incur a loss equal to the difference in prices. In essence, the trader buys gas at a higher price and sells gas at a lower price. When the amount of gas hedged reaches to 100 million cubic feet and the difference in prices equal $0.10 per thousand cubic feet, the loss grows to $10,000.

Timing Between Markets

Each month offers at least two distinct trading periods for obtaining gas deliveries. These distinguishable trading periods require separate analyses, since participants will likely have somewhat different needs. These different needs may lead to different relationships between prices.

Bid week. Guaranteed deliveries for an entire delivery month are completed during bid week. This period lasts only a few days after the futures market closes, and never continues into the delivery month. The average price associated with this period is designated the "average bid-week price."

On average, a close relationship exists between the futures price and the average bid-week price1 published in Inside FERC.2 In fact, the average bid-week

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