Natural gas basis trades reported on the IntercontinentalExchange (ICE) electronic system do not rise to the level of performing a significant price-discovery function (SPDF), ICE said in objecting to the Commodity Futures Trading Commission's (CFTC) proposal to designate 15 natural gas basis contracts as qualifying for SPDF treatment.
In choosing to pursue SPDF status for high-volume gas trading points -- including AEC, Malin, PG&E Citygate, SoCal Border, Northwest Rockies, El Paso Permian, El Paso San Juan, Waha, the Houston Ship Channel, Chicago Citygate, NGPL TexOK, Dominion South Point, Transco Zone 6 NY, Tetco M3 and TCO -- the CFTC failed to recognize that only a small number of trades occur on ICE each day for the different locations, and these contracts are for different forward months, the exchange said. The agency appears to have adopted a five-trade-per-day test, lumping in all the months of each contract and including trades executed as part of seasonal strips, to determine if a contract is materially liquid. But that volume of trade does not qualify as "material liquidity," ICE said in comments on the CFTC proposal.
Also, the agency failed to recognize that trades-per-day statistics submitted by ICE included transactions that were not even executed on the exchange, but rather were executed by voice brokers in the over-the-counter (OTC) market and submitted to ICE after the fact for clearing purposes. These contracts would have had no opportunity to impact price discovery. For nine of the contracts the majority of trades were not executed on the ICE platform and for three others roughly half the transactions were executed on ICE. The AEC contract was the only one that showed a preference for screen trading, with 68% of the contracts executed on ICE.
Even more to the point, an economic expert told the CFTC the financial basis swaps it is considering do not set the price for natural gas. That is done by physical transactions as surveyed and reported by various publications, including Natural Gas Intelligence, with the cooperation of the industry and under guidelines set out by the Federal Energy Regulatory Commission. Rather than price makers, the ICE basis swaps are price takers, deriving their value from actual physical prices of gas, said John R. Morris, a principal at Economists Inc. and a veteran expert witness on pricing issues in the natural gas industry.
Morris said the 15 contracts do not meet any of the criteria the CFTC had previously set out for SPDFs. They do not demonstrate material liquidity; they have a minuscule share of the total Nymex trading volume; and they are not material price references. "Other contracts are not indexed to the financial basis swap contracts, and the market liquidity of the contracts is not robust enough to produce meaningful information on forward prices without a significant amount of additional information and editorial judgments."
Contracts which are found to have significant price discovery impact are subject to reporting, position limits and accountability levels as determined by the CFTC.
The Natural Gas Supply Association (NGSA), also commenting on the issue, noted that the CFTC has already taken steps to secure the Henry Hub basis contract from risk of excessive speculation. The contracts under discussion generally contain a pricing term that consists of the Henry Hub Nymex futures expiry price for the month and the basis differential from an index publisher, NGSA said.
Following up on its designation last summer of the ICE Henry Hub contract, a Nymex look-alike, as having significant price-discovery impact (see NGI, Aug. 3), the CFTC has recently issued a series of notices that it is investigating the above-named natural gas contracts on ICE and in Canada on the Natural Gas Exchange, and a number of electric power contracts that also are traded on ICE to determine their impact on prices (see NGI, Oct. 12).
While noting that the characteristics of the ICE Henry Hub "look-alike" swap were deemed to have potential influence on the Nymex futures values and the underlying physical contracts traded at the benchmark Henry Hub pipeline confluence in Erath, LA, the proposed contracts now under consideration have characteristics that are "materially different" than the previous designation, NGSA said. It noted that the contracts for which the Commission is proposing SPDF status generally contain a pricing term that consists of the Henry Hub Nymex futures expiry price for the month and basis differential produced by an index publisher.
"Further, as opposed to the Henry Hub futures contract, the basis contracts do not, to NGSA's knowledge, have a material effect on other agreements, contracts or transactions listed for trading...on a designated contract market, as is required to be designated a SPDC," Fordham wrote. "The basis contracts are derivative of the Henry Hub futures contract, not the other way around. NGSA is not aware of contracts which are derivative of the basis contracts."
ICE recently notified traders it would put in place CFTC-mandated position limits and accountability levels on its Henry Hub contract starting in February (see NGI, Oct. 26).
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