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Hedging: Basis Troubles Producers; Regulators Constrain LDCs, Says Marketing Exec.

While price volatility challenges everyone in the gas industry, unpredictable basis differentials and a dearth of basis hedging mechanisms have become a thorn in the side of producers especially.

"I still think producers are struggling with locational differences and basis," Griff Jones, CEO of Houston-based marketer Eagle Energy Partners, told NGI. "I think the basis moves have surprised a lot of the producers out there in general. When you get into basis there is a lack of liquidity in the marketplace; there is less information, which means it's harder to educate yourself about what's going on," Jones said. He pointed to last year's basis differentials in the Midcontinent and Canada as evidence of a more complicated market. "We've seen a lot of people surprised by Canadian basis movements, and there's been a general sentiment of asking why the Midcontinent basis has been blowing out so large."

For instance, last July Northern Border Partners LP said that shifting market fundamentals caused a tightening in basis between Alberta and the Midwest U.S. (see NGI, July 18, 2005). The partnership enumerated several fundamentals that it said caused greater basis volatility. Among them was availability of increased Rocky Mountain supply and a redirection of Permian and Anadarko basin gas to Midwest markets.

And some have questioned the validity of prices indexed off of the venerable Henry Hub. "[T]he Henry Hub gas price is increasingly an unreliable proxy for the average gas price that North American producers are realizing," said Cambridge Energy Research Associates' Kenneth Yeasting, director of eastern North American energy, (see NGI, Oct. 17, 2005). In the same story a Rockies producer asserted that indices were driving the market and disconnects were appearing in certain areas. "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."

Jones told NGI that a lack of liquidity in basis markets has kept producers from finding all of the tools they would like to have to manage basis. "For example, if you're on a pipeline that doesn't have a liquid basis market, you may have to trade another basis market that you think is going to emulate where your location is, and I think that's caused a lot of confusion among people who are wishing there was more liquidity," Jones said.

Still, he said that some market fundamentals indicate to him that producers will be able to look forward to a strong price environment for some time to come. "Fundamentally, we're seeing bigger depletion curves and gas-fired generation becoming more prevalent and more on the margin. A hot summer could have a pretty big effect on the supply picture."

While producers are taking greater advantage of financial tools to manage price risk, there are likely a good number of local distribution companies (LDCs) that wish they could do the same. "Every state PUC [public utility commission] probably has a different view on what their LDCs should be doing [to manage price risk]. In general, we don't see many [PUCs] being very proactive in trying to help manage these prices."

Price caps are not the answer, Jones said. "I think it would be nice to let market forces work the way they should. If regulators feel like they need to have a better handle on long-term prices, they should free up the reins a little bit to allow their specific entities...to go out there and implement hedging programs."

While LNG importation could be a stabilizing force in gas markets longer term, the promise of more LNG is creating uncertainty for the time being. "I think there is still a question as to how much LNG is actually going to show up," Jones said. "There have been few new sites actually approved versus all the ones that have been announced, and I think market participants are still trying to figure out which ones are real and which ones are not. There are a lot of people intrigued by the potential effects of LNG, but I don't think anyone really understands what those ultimate effects are going to be."

On the gas demand side, Jones said that a lot of the markets with which Eagle Energy deals don't particularly want to deal with the operational uncertainty engendered in ship-based gas delivery. "Most markets just want to buy flowing natural gas," he said. "They want to buy it in Chicago or in New York or in Atlanta. They don't necessarily want to buy it at the tailgate of some plant and have a lot of force majeure contract language that can be introduced to them. I think there are a lot of contracting issues that need to be worked out on the LNG side, and I think there needs to be a little bit more surety that this LNG is going to be coming here."

Jones is a gas industry veteran, having begun his career 15 years ago with Natural Gas Clearinghouse/Dynegy Inc. He launched Eagle Energy Partners in 2003 with Chairman Chuck Watson, former chairman of Dynegy. Jones is one of four panelists who will speak on the evolution of gas trading at GasMart 2006 May 3-5 in Denver. For more information, visit http://gasmart.com/.

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