Tuesday, June 24, 2014

The Price* - Natural Gas Prices in New Hampshire

I have been away for a while working on energy projects, keeping my energy students busy, and attending conferences. I also had the good fortune to attend a week-long course on the wholesale electricity market in New England that was arranged by ISO-NE, the organization that runs the local electrical grid. I learned a great deal and came away very impressed with the marvelous machine that organizes the electricity market and supply here in New England. I am planning to write about this in a future blog. Our electricity market in New England has become highly dependent on natural gas supply and pricing so I have been keeping an eye on natural gas prices, trying to understand their movement and what drives them.  As is common in the energy world, “price” means very different things to different people and, when doing research on natural gas prices, it can become rather involved rather quickly.

As it turns out, there are three natural gas prices of interest to us here in NH. The first, and on which all the other prices are based, is the basic commodity price for natural gas. This is most commonly referred to as the Henry Hub price and it provides the basis for much of natural gas pricing throughout the US. The Henry Hub is a location in Louisiana where several gas lines converge and radiate out across the US. Although not all the natural gas in the US is routed through the Henry Hub, it is nevertheless the agreed delivery and receiving point for traders and dealers in the wholesale gas market. It is likely that when you hear discussion about natural gas prices or read about them in the financial press, it is the Henry Hub prices that are being discussed.

The challenge here in New England is that we are a long way from Louisiana and other natural gas sources and gas has to be routed through many hundreds of miles of pipelines and multiple compressor stations to get it to us and there is, of course, a cost associated with its transportation. This is reflected in the second of the natural gas prices, which is referred to as the City Gate price. This is the price at which the natural gas is transferred from an interstate pipeline into the distribution network of a local natural gas distribution company, such as Liberty Utilities, the largest of the New Hampshire natural gas companies. The City Gate price is the local wholesale price and reflects the price of natural gas plus the transportation charges involved in getting it from some location to the city gate. The difference between the Henry Hub price and the city gate price is known in natural gas geekspeak as the “basis differential”.  This basis differential does fluctuate, especially in the cold winter months when we are using a lot of natural gas for heating and generating electricity and there is limited natural gas pipeline capacity to get the gas to us.  Because of heavy demand in the winter for pipeline capacity, the basis differential rises.  

Here in New England there are several city gates: the most important for New Hampshire is the Dracut City Gate, where Liberty Utilities picks up natural gas from the Tennessee Gas Pipeline (see End of the Line for a discussion of the local natural gas pipelines of interest to us here in NH). The most commonly discussed and quoted city gate price in New England is that of the Algonquin City Gate in Boston where the Boston gas distribution company, Nstar, taps into the end of the Algonquin Gas Transmission pipeline which brings gas into Boston. Even though there are price variations between the various local city gates, the Alqonquin city gate price is a useful proxy for the local New England wholesale price of natural gas. The figure below shows the average monthly Henry Hub prices and the Boston City Gate prices since 2000. A few key points are noted from this chart.

  • Natural gas prices have fluctuated significantly over the past 13 years, with big spikes in 2005 and 2008.
  • After the run up in natural prices in 2008, natural gas fracking kicked into high gear, supply increased dramatically, and the Henry Hub price dropped to about $ 2/MMBtu. Prices have steadily increased since then and are now of the order of $ 4/MMBtu.
  •  The Algonquin City Gate price is always higher than the Henry Hub price, reflecting the cost of transporting natural gas to New England.
  • The difference between the City Gate and Henry Hub prices, the basis differential, varies significantly over time, with spikes in the high-demand winter months and then dropping off to lower levels in the summer months.
  • The average monthly basis differential over this period was $ 2.93/MMBtu: during some periods it rose as high as $ 6/MMBtu on a monthly basis.

 Data Source: EIA
But now it starts to get complicated. On top of the different city gates locations, there are different prices at the city gates.  There is the spot price, which is the price paid for the purchase of natural gas to be delivered the following day, and then there is the bid week price, which is the price paid for the purchase of gas for the upcoming month.  The term “bid week” comes from companies bidding for next month’s gas during the last week of the present month. The Energy Information Agency (EIA) recently published an interesting chart that compares the bid week and spot prices at Algonquin City Gate in Boston.

Source: EIA
Important to note is that the bid week prices had been reasonably steady, moving between $ 5 to $ 10/MMBtu, since the winter of 2011: however, this past winter these prices increased almost sevenfold to about $ 35/MMBtu. More noticeable are the wild swings in the spot prices this past winter, when they rose as high as $ 80/MMBtu! Those high spot prices had profound effects on electricity prices on those days. For the most part, the local natural gas distribution companies do not purchase large amounts of natural gas on the spot market, but instead use a variety of tools to protect their customers from these large fluctuations.

These include buying natural gas throughout the lower demand summer months, when prices are generally lower, and storing the gas in underground storage caverns in other parts of the country. The natural gas utilities also have some limited local above-ground storage for compressed natural gas. Some local distribution companies (LDCs) also store liquefied propane gas  on-hand to mitigate any short term natural gas shortages.

Besides buying cheap gas in the summer and storing it, the LDCs also use various hedging techniques to protect consumers from wild price fluctuations. Hedging is an interesting and an extraordinary useful financial tool that many organizations use to protect themselves and their customers from commodity price variations. Let’s consider the hedging approaches that an LDC might use to protect their customers from fluctuations in natural gas prices, especially in the cold winter months. There are two main approaches.

The first is the purchase of a certain amount of natural gas for delivery sometime in the future, known as a forward contract. To do this well, the LDC needs to forecast how much gas they will purchase in the cold winter months when there are pipeline constraints and prices climb. The challenge is knowing how much gas to purchase: if they purchase too much, they have to sell the extra; if they purchase too little, they will then be compelled to purchase their shortfall on the spot market which could be very expensive. The amount of natural gas required is very dependent on the winter temperatures and we are all aware of the challenges associated with long-term forecasting of weather conditions. Moreover, there is also a cost associated with locking in a price today for a natural gas that will only be delivered in the future, so invariably  the forward price is higher than today’s spot price.

Another way to hedge future natural gas purchases is to buy and sell financial instruments whose value rises and falls with that of the underlying commodity. These instruments include financial derivatives, such as futures and options. (They are called derivatives because their value rises and falls with that of the commodity from which they are derived.) Consider, for example, if I was a NH LDC and I wanted to lock in a price, say $ 7/MMBtu, for a certain amount of a natural gas price to be delivered in December. Because I am looking to purchase natural gas in the future, I will sell today an equivalent natural gas futures contract today which obligates me to deliver natural gas in December at $ 7/MMBtu. So if we get to December and the spot price of natural gas in December is $ 10/MMBtu I would be paying $ 3/MMBtu more than I wanted to pay in July. However, the value of the futures contract I sold in July to deliver natural gas at $7/MMBtu would have dropped by ~$ 3/MMBtu, and  I can now purchase it back at a lower price. The overall result is that I would have lost money on the rise in spot price of the natural gas but I made money by selling the financial derivative, the futures contract,  high and buying it back low . The money lost on the increase in natural gas price should closely match the money made on the sale and then the repurchase of the derivative, so I should be essentially flat in terms of my price exposure. In other words I am hedged.

Should the opposite happen and the price of natural gas falls between now and December, I would make money because I would be buying the commodity at a lower price but I would lose an equivalent amount of money on the derivative which has risen in price. Again my exposure is flat – and again I am hedged. Because these hedging transactions are a form of insurance, there is a cost, like the cost of a forward contract, associated with purchasing this insurance. NH natural gas ratepayers pay for this insurance through their natural gas rate.  It is important to note that hedging programs do not lower the cost of natural gas - they just serve to lock in prices for future purchases and partially protect rate payers from spiking natural gas prices.

All of this is important because Liberty Utilities, the largest NH natural gas LDC, has recently submitted a proposal to the NH Public Utilities Commission (PUC) to move away from hedging natural gas prices through financial instruments such as options, to simpler forward contracts that involve the purchase of a fixed amount of gas for a specified price in the winter months. The reason for this change is that the older financial derivative hedging program was based on the Henry Hub price where price volatility is now a lot lower (see the first graph). However, these hedging programs did not protect rate payers from volatility in the basis differential, which can be enormous during the winter months.  The newly proposed forward contract program involves delivery of natural gas to the City Gate and therefore includes the basis differential. From my perspective, this appears to be a sound change in the hedging program. However, I did note that between these forward purchase contracts and the use of local and underground storage, Liberty Utilities believes it would be locking in the price of about 57% of natural gas used in the three cold winter months of December, January, and February. This percentage seems low and I would have thought that the natural gas utilities might have done a better job of hedging a larger percentage of their forecasted use. This could be an interesting topic for a future blog.

Returning to City Gate natural gas prices, remember that City Gate is a wholesale price and it is not what we pay for natural gas delivered to our homes: we pay the retail rate, which is substantially higher than the wholesale price.

For NH residents, natural gas is a regulated commodity so prices are set by the NH PUC based on information submitted by the LDCs. Commercial and industrial natural gas customers are able to purchase natural gas from competitive suppliers but this option is not available for natural gas supplied to NH residents. Price setting for natural gas is done twice per year so there are summer and winter prices. However, the utilities have the ability to increase their prices up or down from their approved summer or winter prices, depending on demand and natural gas prices. These interim prices changes cannot be more than 25% of the approved winter or summer rates.

As I noted in Jumping Jack Gas, there are three main components to NH natural gas bills: for clarification, I have included an example of a residential natural gas bill below. There is: 1) a minimum service or meter charge; 2) a distribution charge; and 3) a fuel charge. The minimum service and distribution charges cover the cost of distribution of the natural gas by the local distribution company. As a regulated utility, the LDC can recover all costs associated with distribution as well as earn a return on the capital they have invested into the distribution pipeline infrastructure. On the other hand, the LDC cannot earn a return on the natural gas they supply. They can only pass on the costs associated with the gas they purchase on a dollar-for-dollar basis. These include the wholesale price of the natural gas (the City Gate price), any associated delivery and pipeline charges, and the costs associated with any program aimed at buffering customers from natural gas price fluctuations. These include the costs of hedging and storage programs.

So what are the utilities charging for natural gas once all the costs are factored in? Well, that depends on what utility you are talking about (see Pipeline for a discussion of the two NH natural gas LDCs). The two natural gas distribution companies operating in New Hampshire each have different cost and overhead structures so their rates are somewhat different, as I show in the table below and which compares recent summer and winter rates. The largest of the two, Liberty Utilities, has lower costs, most likely because they have a larger customer base over which to distribute their fixed costs. The distribution costs for Liberty are of the order of $ 3/MMBtu, whereas those for Unitil are almost double that: if you are living in a Unitil service area, you are bearing the brunt of their smaller customer base and higher costs. (Note that natural gas rates for customers are normally quoted as $/therm but I have converted them to $/MMBtu by simply multiplying by 10. See Jumping Jack Gas  for natural gas units and conversion factors.)

When we reflect on all these different prices, it is clear that when we discuss natural gas prices in NH we should always start with the question; “What natural gas price are we talking about?” This discussion has shown that there are three key prices: (1) the Henry Hub price, which is the commodity price for natural gas in the US markets; (2) the City Gate price, which is the local wholesale price and which reflects the costs of transporting the natural gas to New England. The City Gate price is, on average, about $ 3/MMBtu higher than the wholesale price but in the cold winter months this price differential can rocket up. (3) Finally, the retail price is what NH residents pay to get natural gas delivered to their homes. This reflects the wholesale cost of gas plus costs associated with gas storage and hedging programs to buffer residents from big swings in prices. The retail cost also includes costs associated with the distribution the natural gas through the LDC distribution network. These distribution costs are of the order of $ 3/MMBtu for Liberty Utilities and $ 6/MMBtu for Unitil.

I trust that I have been able to guide you through the maze of natural gas pricing and that you have a better appreciation of the challenges and complications faced by the NH regulators and LDC as they work to set prices and protect NH natural gas customers from wild swings in natural gas prices. There is always a price to be paid for such programs, but my assessment is that the price* appears to be a fair one.

Until next time, turn up the temperature on your air conditioner by a degree or two and remember to turn off the lights when you leave the room.

Mike Mooiman
Franklin Pierce University

(*The Price – A great tune by The Steeldrivers. Kinda sorta bluegrass music but it does rock. These guys are out of Nashville and received several Grammy nominations a few years ago for Best Bluegrass Album and Best Country Performance by a Duo or Group. Enjoy The Price) 


  1. The LDCs seem to have missed a very basic financial markets concept called "basis risk". When you want to hedge a risk and you have to use two different assets to do so (here, Henry Hub vs. Algonquin), using futures, options or forwards on the first asset won't protect you fully from market moves in the second asset. So, if you want to hedge, say, your big position in Apple shares, selling puts on the S&P 500 (or Microsoft or any other asset) won't work perfectly, or even well at all, because Apple moves differently than these other assets. The only worthwhile hedge for the LDCs is on the gas price they pay, not some other gas price. One would have thought the regulator (NH PUC) would be on top of such a basic matter and made sure the LDCs got it right. And looking to the future, are forward purchases really the lowest cost solution here?

  2. I do agree that the old hedging program subjected the rate payers to basis
    risk and Liberty Utilities has come to that realization, hence the change in
    hedging approach. However it did seem to take an awfully long time to come to
    that realization. Interesting question about the cost effectiveness of the
    forward purchase program but I would hazard a guess that is perhaps the only way
    you can hedge for delivery at the Dracut City Gate and therefore remove the
    basis risk. I would be interested to learn if there are other approaches.

  3. I've always wondered how was get gas everywhere we need it, and not run out. Also on how they manage to come up with the priced, especially since it's a gas. I thought your page was full of great information it helped me understand a lot better. http://www.seminoletow.com/Roadside_Assistance.html


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