US Natural Gas Market Overview
The purchase of natural gas in most states in the United States is deregulated for commercial consumers.
Unlike most countries, deregulation in the United States is controlled at the individual state level, and therefore, the United States energy market is essentially 50 separate markets. While some states impose minimum annual consumption qualifications, this means that most businesses can competitively source their natural gas requirements.
Typically, these businesses undertake a competitive tender process, issuing a request for proposal, analyzing responses and selecting a supplier based on a set of defined criteria.
Natural Gas Contract Options
In deregulated markets, consumers typically choose between two basic types of supply contracts. The first is a fixed-price contract. As one would infer from the name, this type of contract provides consumers with a fixed price for both the commodity and non-commodity charges (i.e., transmission, distribution, and energy-related taxes). The benefit of a fixed-price contract is that it provides consumers with budget certainty, reduced pricing risk, and greater visibility regarding operating costs.
The alternative is an index-based (or flexible) natural gas supply contract. With an index-based supply contract, a consumer selects a supplier and fixes the non-commmodity or delivery conditions but does not set the price of natural gas. The price of natural gas is based on the index selected in the supply contract.
In the United States, the most commonly used natural gas pricing index is the NYMEX, which is based on the price of natural gas at the Henry Hub pipeline in Erath, Louisiana. NYMEX is used throughout the United States as the de facto benchmark for natural gas prices due to its deep liquidity. Typically, when you see a quote for natural gas prices in the news, the price is based on NYMEX.
Natural Gas Commodity Risk Management
Generally, consumers with index-based contracts can fix (or hedge) some or all of their natural gas requirements for a given month, quarter, or year at the then-current NYMEX market price. This flexibility offers consumers a significant advantage.
Unlike fixed-price contracts, where a consumer must make a single decision on a given day to purchase all their natural gas, consumers with index-based contracts can spread their purchases across multiple transactions, taking advantage of market price fluctuations. Moreover, consumers with index-based contracts can opt to leave some, or potentially all, of their requirements unhedged and accept the monthly market price. In summary, index-based supply contracts allow consumers to better manage risk by determining the optimal balance between price fixing (or hedging) and market price exposure that best suits their business.
Due to the high volatility of natural gas prices, larger consumers opting for index-based natural gas contracts should develop and implement a detailed risk management plan. A well-developed risk management plan will clearly set out a consumer’s overall sourcing objectives, risk tolerance, maximum and minimum allowable hedge levels, and price targets. Entering into an index-based supply agreement without a clear strategy is definitely not considered best practice and typically results in unwelcome budget surprises.
Natural Gas Basis – Risk Management
As stated above, most US index-based natural gas supply contracts are priced off NYMEX. This means that a customer’s price is based on the delivery point in Louisiana.
For the majority of consumers with facilities located elsewhere, this means they need gas delivered to their local facilities. The difference in the price between the Henry Hub delivery point and a client’s local facility is referred to as “Basis.” Similar to natural gas prices, basis prices are highly volatile, particularly during winter periods or severe weather events. Basis prices generally reflect transportation costs, local supply and demand conditions, and other market conditions specific to the particular delivery location. A consumer can fix (or hedge) basis separately from their natural gas.
Basis costs can account for a significant portion of a consumer’s overall cost of natural gas. Therefore, managing basis risk by monitoring the basis market, local pricing, and making strategic purchases (i.e., hedging basis) can dramatically improve a consumer’s overall annual costs.
For more information on arranging and optimizing index-based natural gas contracts and basis, please contact the specialists at NUS Consulting Group. Our US team has deep experience supporting businesses with annual natural gas requirements.