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CERA: Henry Hub an Increasingly 'Imperfect Indicator' of Average Gas Price

While Sabine Pipe Line continues to lift its force majeure on a few more Henry Hub interconnects each day, the question still swirls as to whether or not the hub, which is located near Erath, LA, is still the best proxy for the continental North American gas price. According to Cambridge Energy Research Associates' (CERA) Kenneth Yeasting, director of Eastern North American Energy, the answer is...not anymore.

The argument has people within the industry lining up on both sides of the fence. Some agree there is a flaw, while others classify the argument as "silly."

The Henry Hub gas price plays a major role in North American gas markets, serving as a proxy for the continental North American gas price. The hub is where any physical settlement of a Nymex contract occurs and the North American basis is typically stated as the price difference between a regional location and the Henry Hub. The hub gas price is also the common reference point for many physical and financial products.

"Despite these important roles, the Henry Hub gas price is increasingly an unreliable proxy for the average gas price that North American producers are realizing," Yeasting said in a new study from CERA.

The study points out that in 2000, the Henry Hub gas price averaged $0.18/MMBtu above the production-weighted average supply-area gas price for North America. For the 12 months ended August 2005, the Henry Hub gas price averaged $0.50/MMBtu above that average price, which represents the price producers receive when delivering gas to a pipeline system.

"I think there is a flaw," said a Rockies producer. "What was happening is that the indices were driving how the market was going, which creates a disruption. I have a concern because we are seeing a disconnect in certain areas."

He added that the pricing in other regions of the country should follow their own fundamentals instead of the Henry Hub. "For example, following the hurricanes we saw the Midcontinent area have a basis blowout, so to speak, which wasn't logical. The gas should have basically equalized pretty quickly to a certain level, because there was certainly no trapped gas in the Midcontinent area.

"Depending on how long these problems continue, I think you will see a bit of disconnect," the producer added. "On the other hand, if the problem continues long enough you will see the market react, where basically people will quit using the Henry Hub for negotiational pricing."

As to the idea that another spot could take the torch from the Henry Hub, the producer said he would expect that to be a major problem because people will be resistant. "There is the contractual issue where a lot of gas is contractually tied into the Nymex for contracts, so it would take a bit of time for people to get those type of things unwound. It may take on the order of months before people start to realize that it is not good for their contracts."

Commercial Brokerage Corp. broker Ed Kennedy said he sees the situation differently. "The Henry Hub was just another gathering point in a spider web system," he said. "But when you create a futures contract, you have to pick a spot, like Cushing, OK, for crude. Is that the center of the crude market, no, Rotterdam is, but they picked a spot and the market adjusted to it.

"With the Henry Hub, what has happened is the price structure for the entire industry is on a basis relationship above or below that spot. It's an arbitrary point, which it usually is when you start a futures contract, but the market pricing structure has adjusted to it. People might say it is not the best spot, but it is 'the spot' now because everything else is adjusted to it. It is a silly statement to say the Henry Hub is an increasingly unreliable proxy.

"Why pick an inch instead of a centimeter, well this is the yard stick we chose to use, and the country adjusted to it," Kennedy said. "All of your basis relationships are based on it now, so the Henry Hub is the important spot, even though it is arbitrary."

As for switching the proxy to another point like Chicago, Kennedy said it wouldn't make a difference. "The basis relationships are actively traded now, so because everybody is using the same yardstick -- Henry Hub -- you are in effect trading Chicago, because you can trade the basis relationships."

In the study, Yeasting pointed out that "it is clear" that the Henry Hub gas price "is increasingly an imperfect indicator of the average gas price that North American producers receive." As for the reason behind the widening gap trend, the director pointed to the declining share of gas productive capacity represented by gas supply sources near the Henry Hub (Louisiana, Mississippi, and Alabama on- and offshore gas supply). As evidence, the study points out that these production areas consisted of a little over 30% of North American dry productive gas capacity in 2000, but had slipped below the 30% mark as of 2005. By 2020, the study predicts these production areas are expected to represent 20% of North American production.

In addition, CERA pointed out that swings in trading that temporarily cause dislocations in Nymex prices boil over to Henry Hub physical trading, but have less effect on the less-liquidly traded points of other producing regions. CERA has, since 2003, described the divergence between eastern and western natural gas prices as "the Continental Divide."

CERA uses this concept to explain how short-term or long-term factors can cause gas prices in eastern North American to separate from gas prices in western North America, adding that the divergence of Henry Hub from producing region prices is part of the Continental Divide.

"Although CERA does not expect Henry Hub to lose its central role as a price proxy and reference point, buyers and sellers must take greater care to understand the growing divide between not only East and West basis, but between Henry Hub and other producing regions," Yeasting said.

CERA said the divergence that has occurred since 2000 has generally increased the difference between eastern and western North American gas prices. The company anticipates that the West's share of North American gas productive capacity (or supply gap) will continue to grow.

"Absent substantial new west-to-east pipeline capacity, this will tend to increase the gas price differentials between western and eastern North America," he said. "The significant increase in liquefied natural gas (LNG) imports in the East in 2008-10 will temporarily stop this westward shift from increasing, but it will grow again thereafter."

CERA pointed out that the implications from the West's growing share of gas supply and the resulting expansion of basis differentials between western and eastern markets include:

CERA said the divergence in prices underscores the need for market participants to increasingly focus on regional price formation and basis dynamics -- especially players in the western market. Short-term events, such as weather and supply disruptions, cause temporary swings in the west-to-east gas basis. The study pointed out that Hurricanes Katrina and Ivan were perfect examples because the very substantial impact on eastern gas supply can cause a substantial increase in eastern gas prices relative to western gas prices, especially for southern and northeast markets that have a heavy reliance on Gulf Coast gas supply.

"The Continental Divide has generally resulted in the Henry Hub gas price becoming a less representative proxy for gas prices in North America," Yeasting summarized. "Further, it has contributed to the difference between eastern and western North American gas prices. Buyers and sellers must take into account both the short-term drivers of this east/west price disparity and the long-term drivers that could further widen both the gas supply gap and prices."

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