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.
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
mooimanm@franklinpierce.edu
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(*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)
