Price Tag! - If All Trades Were Index Deals, What Would the Index Be?

Published index prices are the mainstay of most energy commodity markets.  That is certainly true of U.S. natural gas. Of all natural gas deals done in the U.S. last year, almost 80% of the total transaction volume was priced based on an index published by one or more of the industry trade publications covering U.S. gas, such as Natural Gas Intelligence, Platts and Argus.  But there could be a problem brewing.  For publications to compute an index price there must be enough deals reported that are NOT priced on an index - called an “outright” or “fixed” price.  If all, even most deals are done at an index price, there can be no index.  Does that sound a bit circular?  Well it should.  In today’s blog we delve into the sometimes arcane world of commodity index pricing.   Arcane maybe.  But with $150 million in U.S. natural gas moving each day based on index deals, it is worth understanding how all this works, and how things could go awry.  Fortunately, it is possible to know quite a bit about how the U.S. natural gas market uses index transactions.

That is because just about every company involved in the business of buying and selling physical natural gas is required to report their transaction volumes and pricing mechanisms in some detail to the Federal Energy Regulatory Commission (FERC).  Last year (2015), 676 companies filed these reports with the FERC.  That’s crazy you say.  What possible business could the U.S. government have in knowing about every company’s gas deals.  Well, it all goes back to a very dark period in gas market history.  About 15 years ago in the wake of the Enron meltdown, a number of companies and individual traders were charged with intentionally manipulating published price indices by reporting fictitious data to trade publications.  Sometimes the motivation was corporate profits, sometimes it was traders boosting their trading performance, and thus their bonuses. Either way, it was bad.  Fines were levied.  A few traders went to jail.  At that point a number of worried market participants simply stopped reporting their trades to publications to eliminate any risk of being sucked into the morass.  Of course, that meant that a lot less deals were being used to calculate the index prices.  This raised the concern about whether or not the index prices were really representative of the market – a very big deal since so many transactions are based on these indices, including just about all purchases by gas utilities and power generators, and many companies use these indices as the underlying price in the derivative/paper markets. Something needed to be done.

After countless hearings and hundreds of industry comments, on July 24, 2003, FERC issued its Policy Statement on Natural Gas and Electric Price Indices that put a program in place that requires companies that choose to report their trades to trade publications (now called price reporting agencies, or PRAs) to follow a strict set of price reporting guidelines, including the establishment of a formal code of conduct, assigning non-trading individuals to report the trades, and reporting all trades, not just some cherry picked subset.  That provided a lot of certainty for both reporting companies and PRAs, but there was more coming.  A couple of years later, Congress got into the act, passing the Energy Policy Act of 2005, which in addition to authorizing tax credits for alternative energy sources, extending daylight savings time and implementing scores of other provisions, also directed the FERC [in Section 23(a)(1)] “….to facilitate price transparency in markets for the sale or transportation of physical natural gas in interstate commerce.”  The FERC then went into order-making mode, and in 2007 issued Order 704 which requires natural gas market participants of any size to file a new form -- designated the 552 -- which provides aggregated volumes of natural gas purchases and sales, with quantities split out by types of pricing mechanism.  It is an annual form that went into effect in 2009 for calendar year 2008. Companies have been filing Form 552 each year ever since.  FERC compiles all the data and makes it available as a spreadsheet download.   It is a wealth of information that we’ll explore in some detail.

Gas Market Remedial

But before getting into what the latest Form 552 data are telling us, we need to drop back to review how the natural gas market uses index prices.   Like other energy commodities, the sale and purchase of natural gas takes place both through one-on-one bilateral negotiated transactions (including long-term contracts) and through open and transparent trading on organized exchanges.  The market for physical natural gas, in which natural gas volumes are physically delivered from seller to buyer, includes three primary deal structures: (a) the daily physical spot market in which natural gas is bought and sold for delivery the next day, (b) the monthly spot market where gas is sold on monthly contracts for the upcoming month during a period called bid week, a time period 4-5 days prior to the first day of the month the gas is intended to flow, and (c) long-term contracts where gas supply is contracted under seasonal, annual, or multi-year deals. 

Some of the daily spot deals are negotiated outright, at a fixed price (e.g.$2.80/MMBtu) agreed upon between buyer and seller, as are a few of the monthly bid week deals.   Other deals are based on a fixed differential to the Henry Hub (e.g. minus $0.15/MMBtu under Henry), the primary pricing point for natural gas in the U.S. and delivery point for the CME/NYMEX futures contract.  This price differential is called the basis, basis spread, or even more accurately, the location basis between some location and the price on the same day at the Henry Hub. But according to Form 552 data for 2015 (as shown in Figure 1), these fixed price and fixed differential deals made up only about 15% of total transaction volume.  Another 7% of transaction volumes were on miscellaneous deal types, leaving a whopping 78% of deals done at index-related prices.