0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00
NYMEX Strip WTI Oil Prices
Jan 91 Jan 93 Jan 95 Jan 97 Jan 99 Jan 01 Jan 03 Jan 05
The “Gas-to-Gas” competitive period
Hurricane Katrina
The Gas “Price shock” of 2000/2001
“Gas-to-Gas”
competition returns
Oil linkage
$/MMBtu
Source: Jim Jensen
There is some question as to how long gas-to-gas competition will remain the pattern. Those who expect it to be temporary expect a hot summer (with substantial air-conditioning demand for electricity) or a return of hurricane damage to production facilities to restore tight markets and their high, oil-linked pricing to gas.
The return of indirect oil-linkage – and its disappearance in spring 2006 – can be explained by fundamental supply / demand economics. In theoretical commodity pricing, supply rises with increasing price levels at the same time as demand falls. At a market-clearing, price demand and supply are in balance (see Figure 28).
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Figure 28: The Theoretical Behaviour of Supply, Demand and Price; the Textbook Case
Increasing price
Demand decreases with price
Market clearing price
Market clearing volume Increasing volume
Supply increases with price
Gas markets are much more complex, both because elasticities vary for different portions of the market and because of inter-fuel competition. Figure 29 illustrates a much more realistic view of North American gas price formation, reflecting both competition with oil and the differing demand elasticities for different parts of the gas market.
Figure 29: A More Realistic Short-term Gas Supply/Demand Curve – a Market in Gas-to-gas Competition
Increasing gas price relative to oil price
Inelastic premium
demand Inelastic short
term supply
The “Cusp”
where gas prices become decoupled from oil
Increasing volume
Discounted prices Inelastic load
building
In surplus, oil and gas prices are decoupled - resulting in
“GastoGas” competition -prices are volatile
Elastic gas demand in competition with residual oil in switchable boilers
Source: Jim Jensen
Short run supply is comparatively inelastic. In surplus, demand is also inelastic since customers who wish to use gas can get it and the building of additional gas loads through discounting is a relatively slow process. The net result is discounted price behaviour where oil prices do not matter.
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But Figure 30 illustrates what happens to pricing as the market tightens. Competition for short supply quickly bids up prices to a plateau based on heavy-fuel oil price levels (Condition 1 in the Figure).
And if the market is tight enough, residual fuel oil switching capacity is exhausted and prices move towards another plateau set by distillate oil prices (Condition 2 in the Figure). This was the market condition that prevailed during the gas price shock period of the winter of 2000/2001.
Figure 30: Another Short-term Gas Supply/Demand Curve – Two
Oil and gas prices recoupled - residual fuel prices set a cap on gas prices - Prices may be more stable but are exposed to oil price risks
Oil and gas prices still
During the extended period of oil linkage from 2001 to early 2006 (except for a brief return to gas-to-gas competition during 2001), prices have tended to float between residual fuel oil parity and distillate fuel oil parity. Tight markets have driven them towards the upper bound, but weak markets have let them fall back towards heavy fuel oil price levels.
4.2.6.4 Current north american Price relationships
The physical spot market in North America is highly volatile, but participants in the market make use of derivatives to manage price risk. The New York Mercantile Exchange (NYMEX) offers futures contracts for a seventy-two month period into the future, but the liquidity of the contract deteriorates rapidly for longer-term contract settlement dates. Even longer-term transactions are possible using over-the-counter ‘swaps’, but again liquidity may be a problem.
Spot natural gas prices and individual month futures prices can be quite volatile and are affected by seasonality. One means of getting a more stable measure of gas prices is to utilise the NYMEX ‘strip’
pricing series. This averages the next twelve months of futures contracts, effectively eliminating the seasonality of the spot price series. While strips and spot prices roughly follow similar trajectories,
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strips eliminate most of the short-term highs and lows. Figure 31 compares Henry Hub spot prices and NYMEX strips since 2003.
Figure 31: The Relationship between Spot Prices and the NYMEX Strip Price at Henry Hub
Jan 03 Jan 04 Jan 05 Jan 06
4.00 6.00 8.00 10.00 12.00 14.00
NYMEX Strip Henry Hub Spot
$/MMBtu
Market basis differentials relate the price at other hubs to the price at Henry Hub. Figure 32 compares the basis differentials for several market hubs – New York, Chicago and the California border. As is apparent, there is comparatively little variation between the Chicago price and Henry Hub, suggesting a limited price driving force to attract Gulf Coast supply to the upper Midwest.
The gas price shock of 2000/2001 was accompanied by a severe energy crisis in California. Figure 32 illustrates how high California prices rose relative to prices in other parts of the country. Since that time, however, California border prices have usually been below Henry Hub prices. This suggests that the real physical balancing point5 lies to the west of Henry Hub.
The fact that Henry Hub is not the neutral pricing point on the system is confirmed by the fact that peaks in New York pricing tend to coincide with sharp negatives in California prices. Cold East Coast weather conditions presumably drive up not only market hub prices, but Louisiana prices, as well.
Thus the negative California basis differential is the result of strengthening Henry Hub prices, rather than weakening California prices.
35. A hypothetical ‘neutral point’ where the costs of moving gas to the East Coast or the West Coast are similar.
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