I will Survive – Making Money with Natural Gas Storage in the Shale Era

The shale revolution has done away with natural gas price volatility, at least for now.  And that has been a bad thing for natural gas storage.  Merchant storage facilities make most of their money on either seasonal gas price differences or short-term price fluctuations, or both.  Unfortunately, the oversupplied market has flattened out prices, removing the primary source of storage value.  But there are other ways of extracting value out of natural gas storage. Today we explore several of these strategies.

In the most recent blog in this series titled Bright Lights, Big City – Natural Gas Storage by Region we looked at how the value of natural gas storage within each region varies depending on whether that area is a net producer or net consumer.  We also observed that the explosion of natural gas production (35% increase in the last 7 years) as a result of the shale gas revolution has turned the spot and forward markets which in 2006-08 were as tumultuous and volatile as grunge rock, into something more akin to elevator music. Previously, in the first installment of this blog series Come on, Feel the Noise: Natural Gas Storage - The Signal and the Noise we saw that the value of storage is almost entirely dependent on price variation.  With price volatility evaporating, the economics of natural gas storage as a merchant investment doesn’t look so good these days.  The question you might be asking yourself is in what other ways do these storage facilities provide value to customers? In this episode we will explore the rest of the story by examining the characteristics of individual storage facilities and their value adding services..

Most businesses try to diversify their activities to manage marketplace risks. Take a local bank. Anyone who has suffered through a “Principles of Micro/Macroeconomics Course” knows (or at one time knew) that the main service banks provide is as a financial intermediary between savers and borrowers (you may remember the "Money Multiplier" concept).  But we also know that banks  engage in all sorts of other services like safety deposit boxes, or credit counseling or financial planning, tailored so that they can serve the local market in a more diverse (and presumably profitable) way. In the same way storage facilities will provide services similar but not identical to the "buy now sell later" business model we have discussed so far to meet their customer’s needs.

Buy Now, Sell Whenever

Before getting into the nitty gritty, let’s look one more time at the "buy now sell later" business model. Recall the two ways that storage is used to capture value using this model.  One is simply the difference between seasonal prices – buy in the summer when prices are supposed to be cheaper and sell in the winter when prices are supposed to be higher.  This is called capturing “intrinsic value”.  The other way to capture value is from short term price changes (called “extrinsic value).  This requires that the storage facility switch from injection to withdrawal quickly. We call switching from injection to withdrawal and back again a "turn" so obviously those facilities which can do this more quickly (high turn capability), like salt dome reservoirs, provide more value to their customers that need this service. The primary transaction through which the "buy now sell later" business model is executed is the storage lease. As the name implies the storage lease is simply a shipper or trader leasing a set capacity of a storage facility from an operator for certain length of time (along with other considerations). Such a high turn storage lease gives the lessee a dedicated volume that can be used to store gas one day and literally sell it the next.  Or whenever.  Of course, the lessee pays for the storage capacity whether or not it is used.  So if the volatility doesn’t provide the opportunity to buy low and sell high, the lessee has a problem. 

A number of natural gas trading companies including Wall Street banks leased storage during the heyday of gas price volatility to capture those big ‘buy now, sell later’ spreads. Recently though, the percentage leased by these speculators has, for the first time in years, begun to fall due to reduced  price volatility.  As it turns out, commodity trading desks are much bigger fans of grunge rock than Muzak, (see Bright Lights, Big City - Natural Gas Storage by Region ). The result has been declining lease revenues for some storage facilities.

Peek-a-boo I see you

Some storage facilities are weathering the decline in revenues better than others – particularly those that are liquid trading hubs. A “hub” is a place where gas is bought and sold typically an interconnect between major pipelines or a delivery point close to market. Liquidity at a trading hub is a measure of the volume of transactions. The more trades that are done at a hub, the better the chances of finding counterparty you can do business with. Liquidity makes it easier to get into and out of positions. Trading hubs also need to offer transparency – information about the volume and level of prices for transactions – generally reported by industry price reporting agencies.

Transparency is important because it provides market participants with a higher degree of confidence that deals are transacted at a fair market price.  As transparency increases, so does hub trading activity which means more opportunity for storage operators to capitalize on market activity. One of the value add services that a storage operator may provide is that of market maker. This service consists of a commitment to buy and sell gas or storage space on their own account at prices visible to the market (usually electronically). In this way a market maker increases liquidity and transparency at the hub – making it more attractive to participants.

Creating Value with Natural Gas Storage

A number of additional value add services are offered by storage owners as follows:

• Do You Valet?  One of the ways in which storage facilities derive value from the increased liquidity in the proximity of an established hub is to provide park and loan transactions to market participants. A park transaction is a one-time agreement in which a shipper delivers gas to a storage operator and receives the same amount of gas back at a future time.   Effectively parking it is a very short term storage lease. For example if the ICE Henry Hub spot price is $3.75/MMbtu and the one-month forward price is $ 4.25/MMbtu there is a $0.50/MMbtu park opportunity. Unfortunately, these days monthly differentials between spot and forward prices rarely experience such wide spreads.  In fact, on Wednesday the July 3rd “ICE” spot gas price at Henry Hub was $3.54/MMbtu while the August CME/NYMEX futures price was $3.69, only a $0.15 differential.  That’s a pretty skinny margin for a park and loan deal.
• Come on! Give me some credit!  Sometimes the price differential can go the other way, so that next month’s price is below today’s price.  That is called ‘backwardation’, and  storage facilities can create value in this circumstance by loaning or advancing gas in exchange for receiving that amount of gas back at a future time. This is equivalent to "going short" in the stock market. A customer borrows gas when spot prices are high in the expectation that they will fall. The gas is then sold immediately and repurchased later – hopefully at a lower price – and returned to the storage provider.. For example if today's spot price is again 3.75 $/MMbtu and if the one-month forward price is 3.25 $/MMbtu there is a $0.50 $/MMbtu loan opportunity available.  Don’t get too excited. On Wednesday the August NYMEX futures price of $3.69/MMbtu was only one tenth of a cent above September ($3.689). Hard to make money on tenths of cents.
• Wheeling and Dealing, and have I got a deal for YOU.  Another valuable characteristic of a storage facility is the number of high volume pipelines that it is connected to. First of all, having access to several interconnecting pipelines provides a storage facility a large, diverse customer base since shippers on each pipeline have unique interests in reserving capacity. Second, the price volatility from which facilities derive their value is driven by capacity constraints that occur at different times on different pipelines. This means that a storage facility connected to multiple liquid hubs is well positioned to arbitrage (buying low at point A and immediately selling high at point B) between trading points by allowing customers to capture the price spread between them. One of the ways that storage facilities make capturing value through arbitrage available to their customers is called “wheeling” service. Wheeling is the use of the facilities header pipeline to transfer gas from one pipeline to another. As you might imagine at times when there is large margin between spot prices at two connected hubs, say A and B, there is a high demand for moving gas from lower to higher priced pipelines. For example if the spot price at hub A is $5.00/MMbtu and the spot price at hub B is $4.50/MMbtu then there is a $ 0.50 MMbtu wheeling opportunity on that day. The more liquid market centers that a storage facility has access to, then the more opportunities it has to benefit from wheeling transactions.
• A Captive Audience.  Storage facilities fortunate enough to have dedicated “on-system” customers like residential gas distribution systems or a nearby power generation facility are able to provide those customers with reliable backup and standby natural gas supplies at attractive prices. For example, one of the more important services that a local storage facility can provide to a nearby natural gas power generation facility is imbalance management. Imbalance management is a fee-based transaction designed to accommodate inconsistencies in perfectly matching supply and demand. Suppose that in anticipation of hot weather over the weekend a natural gas fired power plant purchases 10,000 MMbtu of gas from a supplier to be delivered over a three day period (Saturday through Monday) on a regulated interstate pipeline. Interstate pipelines operate under a highly regulated set of scheduling rules [1] so the gas is nominated (scheduled) for delivery on the pipeline’s “EBB” scheduling system [2]. Now suppose that the weather turned out to be cooler than expected, and as a result the power plant did not take delivery of all the scheduled gas. By Monday the power plant would have accumulated a positive “imbalance” on the pipeline meaning there is undelivered gas still in the pipeline, stored as "linepack" (effectively an inventory). If the imbalance is outside the pipelines imbalance tolerance specified in its tariff, the power plant could be assessed a significant penalty by the pipeline in the range of $50/MMbtu, many times the current value of the gas! To avoid these penalties the power plant can prearrange a park transaction with a storage operator to hold that imbalance so that it can be used or sold at a later date. The opposite situation is also dealt with similarly, if the power generator under estimates its gas needs it can prearrange loan transactions with storage facilities to avoid negative imbalances.