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Gas Price Behavior: Gauging Links Between Hubs and Markets

Fortnightly Magazine - April 1 1996

price can be expressed as the futures price plus a small random amount. This random amount remains unpredictable (em sometimes negative and sometimes positive (em and carries an expected value of zero. Thus, if a company closes out its futures contract position near the termination of the futures contract market and regularly completes its cash transaction during bid week, then, on average, it obtains a perfect hedge. In other words, over time, positive and negative differences between cash and futures prices balance out.

Nevertheless, irregular or infrequent users of the futures market still run significant risk, since the futures settlement price at the close of trading of a futures market and the bid-week price at the Henry Hub can differ significantly. In the last several years, for instance, the difference has run as high as $0.10 MMBtu.

After Bid Week. Marketing and other companies with active trading units regularly engage in both bid-week market and market after bid week to take advantage of commercial opportunities afforded by engaging selectively in both markets. The average of the deals completed during and after bid week is designated as the "average overall spot-market price." This price and the futures price don't converge, on average, but do share a systematic relationship.

An average relationship can be estimated by subjecting price data from the New York Mercantile Exchange and Natural Gas Week to regression analysis.3 The average overall spot market price can be expressed as $0.26 MMBtu +

(0.84 x futures price/MMBtu) +

a random amount. Based on data for June 1990 through September 1995, a high futures price indicates a low spot price: When the futures price is $2.30/MMBtu, the expected spot price is $2.19/MMBtu ($2.19 = $0.26/MMBtu + 0.84 x $2.30/MMBtu). Thus, when the price is high, a producer should sell as much gas as possible during bid week, rather than after.

Nevertheless, dangers remain hidden in such average relationships. Factors that influence the market can change systematically in unexpected ways. For example, from October 1995 through January 1996, temperatures lingered consistently below normal. Weekly storage levels consistently fell farther and farther from levels for the same week in the previous year. The perception of dangerously low storage levels and the fact of consistently lower-than-normal temperatures induced a trend-like behavior, with higher prices in the market after bid week. For example, the average overall spot-market price for December was $2.45/MMBtu; the futures settlement price at closing day came in at $2.24/MMBtu.

Despite such periodic anomalies, the expected average relationship between prices may manifest itself again. The average systematic relationship may reflect 1) regular differences in the quality of the information available during the two trading periods, 2) different needs satisfied by the market

during and after bid week, or 3) a different mix of industry participation with different trading capabilities in both markets.

Traders can make use of other, similar average relationships to gauge the viability of using an indexed contract to represent a market price, or of using the futures market to hedge price risk at locations far from the Henry Hub. Such average