GAS FUTURES CAN HELP INDEPENDENTS MANAGE THEIR RISKS

John Elting Treat
Matthew C. Rogers
Booz-Allen & Hamilton Inc.
San Francisco

The advent of natural gas futures trading presents the natural gas industry with a powerful tool and a formidable challenge. On the one hand, producers, pipelines, local distribution companies (LDCs), end-users, and marketers can use gas futures to hedge against price risk, protecting companies against abnormal price spikes, stabilizing cash flows, enabling companies to write long-term contracts, and facilitating planning. Gas futures can also be used in combination with oil futures to hedge against fuel switching.

On the other hand, the introduction of natural gas futures trading will dramatically reshape the natural gas business. Natural gas companies from smaller independent producers to large end-users will be forced to adapt. Short-term price volatility will tend to increase. At the same time, long-term price volatility should decline. Information flows will increase. Oil and gas prices may become more closely linked. Futures prices will become benchmarks for formula-priced contracts. Increased longer-term and mid-month contracting will reduce the current reliance on month-end spot market contracts. And new players will enter the natural gas business. As a result of these trends, natural gas companies will need to adopt new strategies, systems, and organizational structures in order to remain competitive. To succeed, even companies that initially do not trade in the futures market must understand how futures will change the structure of the business.

A NATURAL DEVELOPMENT

The changing character of the North American natural gas markets made the introduction of natural gas futures trading inevitable. Since deregulation, natural gas prices have become more volatile. In the face of volatile prices, spot markets have exploded. Changing federal regulations have fragmented traditional supply relationships. Attracted by the expansion of spot trading and the deregulation of supply relationships, gas marketers and traders have entered the market (Fig. 1). Firms from the independents at the wellhead to electric utilities at the burner tip have faced substantial price risk but have had few tools to measure or manage that risk.

Contracting for supply and transportation capacity has become a complex and, at times, uncertain process. For the last several years, prices and transaction volumes have been set in a flurry of independent spot market transactions during the last 10 days of the month. in negotiations and in planning, the market has relied on posted prices (which may be discounted for certain customers) and surveys of prices (which may be unreliable indicators of market strength, levels, and trends). The net result has been a highly fragmented market with some pricing inefficiencies. Given these limitations, the spot market system is working surprisingly well, but the natural gas market now requires more powerful and flexible tools.

Futures provide a simple, cost-effective method to hedge price risk and to improve contracting efficiency. Futures contracts can be used to substantially reduce the impact of unexpected price movements on the profitability of natural gas companies. In essence, the futures market allows firms to transfer price risk from their portfolio of physical assets to the more highly liquid paper market. There the market can match offsetting positions of various hedgers while traders and speculators step in to accept the remaining price risk in exchange for the opportunity to make significant profits.

Moreover, the futures market facilitates the introduction of swaps, caps, collars, and floors and other off-exchange hedging products by allowing banks and other financial intermediaries to hedge their risks while they structure a transaction.

The existence of a futures market also provides a public, highly visible benchmark for prices, making spot contract negotiations more equitable and efficient. Since futures prices result from thousands of transactions in one unified market, futures prices provide more-frequent and reliable information than spot prices on current price levels, trends, and market confidence.

Futures prices from forward months represent the industry's collective expectation of future prices. These visible long-term price expectations should lead to more rational long-term decisionmaking from both suppliers and consumers.

Finally, the futures market provides the natural gas market with much needed mid-month liquidity. With a working futures market, prices can be locked in well in advance of the month-end spot market capacity bidding cycle. As the natural gas industry moves from a position of excess supply (the infamous gas bubble) toward supply/demand equilibrium, the ability of the futures market to improve the efficiency of the natural gas industry through hedging, price signaling, and enhanced liquidity is particularly important.

PRACTICAL USES

The futures market exists because natural gas companies, like companies in other commodity industries, require a mechanism to manage price risk. Once this hedging mechanism is introduced, however, it also becomes an important competitive tool.

Producers can use futures as an insurance policy and as a competitive tool (Fig. 2). For example, a producer who is concerned about abnormal summer price declines can short futures a season ahead to lock in prices in advance, eliminating the downside risk. Alternatively, a producer who is concerned about losing customers to oil if oil prices fall while gas prices remain firm can buy gas futures and short oil futures, using the futures earnings as a competitive tool to prevent or offset fuel-switching losses.

Producers can also increase their borrowing capacity by shorting futures up to 1 year in advance, establishing a guaranteed cash flow stream which will allow loans to be secured by reserves in the ground. Also, producers can use futures to hedge against abnormal month-to-month price swings by executing a straddle-buy futures where prices may be high and short futures where there is a risk of abnormal price declines.

Pipelines can use futures to match the pricing characteristics of take and delivery obligations. With futures, pipelines can also hedge against demand fluctuations caused by bypass and fuel switching.

Finally, pipelines can hedge against unusual month-to-month price swings using futures.

Marketers can reduce the risk of having an uncovered position (an obligation to buy without a corresponding obligation to sell, or vice-versa). Also, marketers can use futures to match contract pricing characteristics (e.g., fixed versus floating prices) between buyers and sellers.

With public utility commission approval, LDCs can substantially reduce fuel price risk and preserve fuel-switchable load through the use of futures contracts. As the market matures, futures should become a critical competitive tool for LDCS, benefitting ratepayers and shareholders alike.

End-users can enhance their competitiveness and increase their ability to plan long-term by using futures to stabilize input prices and to hedge against adverse shifts in the spread between gas and oil. An end-user can fix the energy cost component of a product by buying a series of gas futures. This hedging transaction can enable the end-user to fill a long-term, fixed-price contract at a fixed profit margin. By buying gas futures and selling oil futures, an enduser can engage in paper barrel fuel switching; using the futures market in this way will allow an end-user to contract for gas long-term and still profit if oil prices fall.

Some local markets will find it more difficult to use futures effectively as hedges because of location basis risk (the risk that the spread between the price in a particular region, like the Rocky Mountains, and the price at Henry Hub will not remain constant). However, we believe most markets will find the location basis risk manageable. As long as the spread between two regions is driven by the underlying supply/demand and transportation balances, this spread should remain relatively stable, allowing market participants to use futures-based formula pricing and to hedge price risk with futures.

However, if local prices spike due to an unexpected transportation bottleneck while the Henry Hub price follows a normal path, then futures-based hedges will be ineffective. Most natural gas companies will wait until the level of basis risk is clearly defined by at least a full year of experience before beginning trading. Once the stability of location basis is established, the market should grow rapidly.

We believe the other form of basis risk, cash/futures basis risk, also will not become a problem in the natural gas futures market. Cash/futures basis risk is the risk that the spread between the spot market price and the futures price will not remain constant (Fig. 3). The experience from the oil futures market suggests that the cash/futures basis risk is quite manageable. The cash/futures spread should be driven by the time value of money and normal seasonal price fluctuations. At the end of the month prior to delivery, the futures price and the cash price should converge to parity.

However, market imbalances may occur in either the spot market or the futures market. In these instances, the spread between the cash market and the futures market may change as the unbalanced market seeks a clearing price. These market imbalances can reduce the effectiveness of hedging. Yet in practice, the cash/futures basis risk appears negligible, particularly in highly liquid markets like the crude oil futures market.

Those who are concerned about basis risk should not forget that basis risk can also represent a profit opportunity. Spreads can move both positively and negatively. Because of the opportunity to profit from basis shifts, new instruments may emerge to hedge basis risk as the natural gas futures market develops.

GAS BUSINESS EFFECTS

If, as we expect, the futures market continues to develop successfully, the mere existence of a natural gas futures market will change the structure of the natural gas market. The futures market will make the natural gas business more visible, more efficient, and more competitive.

The value of information will rise in the new trading environment. Information flows will increase and accelerate. This trend will give rise to new publications, more online price data, and expanded electronic postings of local price and transportation capacity information. In general, information about the natural gas industry will be more voluminous, complete, detailed, and timely.

As the volume and velocity of information increase, the spot market process will be streamlined. Shorter bidding periods, faster cycling of transportation capacity data, and more-efficient processing of mid-month transactions will result. Actual spot market volumes may decline over the next few years as longer-term indexed contracts become more popular. However, spot market pricing will remain a critical determinant of formula-based contracts.

Short-term price volatility may well increase. The market will react quickly to rumors and new information. Traders and speculators will attempt to profit from unexpected changes in demand and supply caused by unusual weather, unexpected oil price movements, and changing transportation/storage conditions. Day-to-day and intra-day price variations may be substantial.

However, long-term price volatility may decline. Futures prices for forward months should send clear signals about future price expectations to the market. These signals should allow market participants to make more-informed and rational long-term decisions about how much supply and demand the market can support.

Also, the futures market will give gas companies a continuous opportunity to hedge against idiosyncratic events. This ability to place a bet on price expectations and to hedge against dramatic, unexpected price swings should dampen volatility in the cash market when unusual supply or demand conditions exist. The futures market will give the natural gas industry more information and greater liquidity, enhancing the long-term efficiency and stability of the market.

Natural gas contract prices will increasingly be based on formulas indexed to futures prices. Longer-term indexed contracts may complement short-term and spot market transactions. The EFP (exchange of futures for physicals) and ADP (alternative delivery procedures) mechanisms in the futures market will provide new means to contract for supply. Similarly, other off-exchange markets, like the forward market on the Enron system, will give producers new opportunities to sell their product while giving end-users alternative buying mechanisms.

The relationship between gas prices and oil prices may grow closer. Public oil and gas prices for similar futures contracts will be compared on a dollars-per-MMBTU basis. Intermarket hedging and arbitrage may explicitly link the price of gas to oil or a competing fuel. However, as the performance of the natural gas futures market following the Iraq crisis demonstrated, visibility will not override the underlying supply/demand conditions in the oil and gas markets.

Inventory planning based on futures prices should stabilize the price relationship between alternative fuels. Moreover, as we indicated above, the existence of parallel futures markets for gas and oil may change the dynamics of fuel switching; paper barrel transactions can replace physical fuel switching in some cases.

Finally, speculators and "Wall Street refiners" will enter the market. These new players will bring a new set of techniques and strategies to bear on the industry. Some of these techniques may include creation of a wider variety of "off-exchange" instruments including specialized options, forward contracts, collars, caps, floors, and natural gas "swaps."

Over time, these new instruments may tend to offer longer term price protection, which may in turn increase the demand for longer term futures contracts. Natural gas companies will begin hiring traders in addition to geologists, pipeline engineers, and lawyers. The emergence of those new players may breed new conflicts within the industry: short-term versus long-term goals, paper molecules versus physical assets, one price versus many prices. However, over time, new constructive alliances should result.

CHANGING MANAGEMENT STRATEGIES

To remain competitive in this market environment, natural gas companies will need to become more sophisticated and more skilled about the strategic management of market risk.

In this environment, unexpected events will not affect companies equally. Those companies that are prepared and act on the basis of a sound understanding of risk will be rewarded. Those that are unprepared will be punished by the market.

Management will need to develop trading savvy, emphasize strategic vision, improve organizational flexibility, and increase information processing capabilities. The traditional skills which natural gas companies possess-geological skill finding gas, engineering skill transporting and delivering gas, and political skill navigating through the regulatory process-will not be enough to survive in this increasingly complex and competitive marketplace. Companies which adapt to the changes will prosper; those which neglect to make the necessary changes will likely fail.

We believe that companies with substantial risk exposure to natural gas price fluctuations need to apply an integrated approach to risk management (Fig. 4). These companies need to audit their operation to identify risks. Then these risks need to be assessed across a range of probability-weighted scenarios, including crisis scenarios.

Companies should emerge from this two step analysis with a clear understanding of how price fluctuations will affect firm profitability depending on the timing of price fluctuations, the magnitude of price fluctuations, and the impact of these price fluctuations on fuel switching.

With this knowledge in hand, the companies can begin to evaluate their needs for new strategies, new organizational structures, and new systems. The truly successful companies will quickly implement programs which will make managing price risk an integral part of day-to-day operations.

The market will reward those companies with a well defined strategic vision. Price forecasts, supply forecasts, and demand forecasts matter more when risks can be hedged than they did when every company was equally vulnerable to the whims of OPEC decision-making. Likewise, with increased price risk, companies may wish to consider geographical diversification, fuel diversification, and upstream or downstream integration.

In selected cases, these strategic shifts can offer firms important competitive benefits in this new market environment.

Finally, firms need to rethink their role in the market. Producers, pipelines, distributors, and marketers should consider offering hedging services to their customers. Those firms that develop strong hedging skills could develop a significant competitive advantage by providing such high value services.

Natural gas companies will also need to adopt more-flexible organizational structures to remain competitive. Market imperatives must be driven down to each decision-making level within the firm. Decision-making processes must be streamlined to improve the firm's ability to react to fast moving market opportunities.

At the same time, controls must be implemented to avoid speculation and excessive risk taking. Information flows will need to increase so that decision-makers at all levels have access to quality information on a timely basis. Finally, compensation systems should be adjusted to provide incentives which reflect a market-driven orientation.

To support these new strategic directions and organizational structures, firms will need to adopt more-sophisticated systems technology. Information systems must be updated to provide immediate access to data on portfolio risks and opportunities in the cash market and in the futures market.

These information systems need to link production decisions to market actions; connect contracting decisions to a long-term strategic vision of prices, demand, and supply; balance geographic risks and opportunities; and identify short-term and long-term profit opportunities. Also, accounting systems should be implemented to track margins, measure profits and losses, and assess the success of hedging activities.

There is no doubt that the introduction of natural gas futures will make the job of a natural gas manager more difficult. Instead of making portfolio decisions quarterly or even monthly, each manager will have the opportunity to readjust portfolio duration and pricing characteristics daily. Moreover, the line managers' decisions will be exposed to increased shareholder and management scrutiny because price movements will be more visible, public, and perhaps more volatile.

As a result, managers will need to have well developed natural gas price forecasts and immediate access to information on portfolio performance. The risks for these managers will increase; hopefully, the rewards will increase commensurately.

EVOLVING CHARACTER

Few natural gas market participants will immediately dive into futures trading. Most industry participants will wisely wait on the sidelines until the market becomes more developed and establishes a track record of manageable basis risk.

For each firm, the tactical decision to trade or not to trade depends on the magnitude of price risk exposure, the degree of location basis risk, and the firm's risk preference profile. Among the firms for whom trading makes sense, those firms that have the people, systems, and strategies to support trading will enter the market first,

Marketers and traders will be the first players in the futures market. Many of these players already possess the people, systems, and organizations necessary to profit from futures trading. These are also the players for whom price risk represents the single most important determinant of profitability.

Marketers and traders will also be the first groups to experience a shakeout as a result of the introduction of futures trading. Those marketing and trading firms which learn to use hedging tools effectively will win. Those which fail to adapt quickly will find their profit margins squeezed and their competitiveness diminished. Many marketers and gas traders will fail.

As the futures market develops, pipelines and end-users with large profit exposure to natural gas prices will begin to trade. Some of these end-users already hedge their crude oil supply needs with futures and options. Pipeline marketing groups have also begun to develop the people resources and the information systems to incorporate a gas hedging program in their risk management strategy. It will not be difficult for these players to apply these techniques to natural gas futures hedging.

Finally, as the market matures, small producers, endusers with moderate gas exposure, and LDCs with enlightened regulators will begin trading as well.

Each of these groups needs time to develop the people and the systems necessary to manage a hedging program.

LDCS, in addition, need to undertake significant negotiations with their regulators to develop a consensus on how hedging gains, losses, and expenses should be allocated and accounted for. Without this organizational, systems, and regulatory preparation, using futures could create more risks than it eliminates.

Large producers, end-users with low energy dependence, and LDCs with restrictive regulators may not be able to benefit from futures based hedging strategies even after the market is well developed.

Large producers are often too large to utilize a futures market effectively. A large producer trying to hedge a large portion of its portfolio would have a significant impact on futures prices overall, reducing the value of hedging for its portfolio. Alternatively, if a large producer decided to hedge only a small portion of a large portfolio, this would do little for the firm's overall profitability and creditworthiness.

End-users with low energy dependence will find that the costs of futures in terms of time, talent, and cost outweigh the benefits. The risk exposure must be significant for the insurance embedded in hedging to have value.

LDCs with unenlightened regulators will either be prohibited outright from trading or allowed to trade only under onerous conditions that allocate the benefits to the ratepayers and the costs to the shareholders. If regulators do not view futures as an integral feature of the increasingly competitive natural gas marketplace, successful LDC futures hedging is unlikely.

If the oil futures market provides a guide, the natural gas futures market should mature over a 4-5 year period, starting relatively slowly and then taking off (Fig. 5). The futures contract for No. 2 fuel oil started very slowly but has grown steadily in popularity. It began trading less than 150 contracts (150,000 bbl)/day in 1979, the first full year of trading for the contract. By 1983, the market was trading over 7,400 contracts/day. Since then, the market has grown steadily at about 20%/year. In 1989, the market traded almost 23,000 contracts (23 million bbl)/day.

The crude oil futures contract enjoyed strong initial popularity and spectacular growth. It began with an average trading volume of almost 1,700 contracts (1.7 million bbl)/day in 1983 and grew to boast an average trading volume of almost 82,000 contracts (82 million bbl)/day by 1989.

This represents a compound annual growth rate of approximately 90%. However, this growth rate is likely to decline over time.

In the wake of the Iraqi invasion of Kuwait, the crude oil futures market provided an important source of liquidity and price transparency. Volume in the crude oil futures market reached almost 200,000 contracts/day following the invasion in early August.

Prospects look good for the natural gas futures market. Trading volume has been strong and growing. For the first 117 trading days (Apr. 3-Sept. 17), the natural gas futures market traded an average of 525 contracts/day (5,250,000 MMBTU, equivalent to approximately 875,000 bbl of oil). This compares with an average volume of approximately 830 contracts/day for the first 117 trading days in the crude oil futures market after it opened in 1983.

The number of open positions (two-sided, uncovered contracts to make and take delivery; i.e., one long plus one short equals an open interest position) in the natural gas futures market has grown steadily, showing strong market support for the natural gas futures contract. From a level of over 4,000 open positions at the end of June, the number of open positions grew to 11,223 open positions as of Sept. 19, 1990. This compares with 8,750 open interest positions in the crude oil futures market at the same time in its development.

The history of participation in the oil futures market suggests that as the natural gas futures market matures, hedgers will replace speculators as the dominant players in the market (Fig. 6). Between 1983 and 1988 the total number of open positions for No. 2 fuel oil futures grew 65%, but the number of speculative positions declined 38%.

As a result, marketers (55%), refiners (21%), and end-users (9%) dominated the market by 1988 using futures as hedges rather than as speculative tools. Speculators, who accounted for 40% of the open positions in 1983, accounted for only 15% of the open positions in 1988.

The initial experience with the natural gas futures contract bears out this assessment. The New York Mercantile Exchange (Nymex) reported in June that approximately 68% of the open interest positions were held by marketers, 25% by producers, 6% by trading companies, and only 1% by speculators.

The experience with the oil industry also suggests that the introduction of natural gas futures will stimulate growth of other markets. Once liquidity is established in the futures market, Nymex will introduce options on futures. Options on futures may be more useful hedging tools for companies which want to invest a small amount of capital to protect against extreme risks.

Forward markets will also grow, particularly in those geographic regions where the location basis risk is too large to use Henry Hub as a basing point-Enron's offer of five delivery points for forward contracts is just the beginning. Finally, a market for swaps and other longer-term off-exchange instruments may develop.

CONCLUSIONS

The natural gas futures market provides natural gas companies with a much needed, practical tool to manage price risk. Firms from the wellhead to the burner tip can now hedge against the adverse effects of unexpected price movements in a highly liquid and efficient market.

Hedging will play an increasing role in the natural gas industry's improving profitability outlook over the next several years.

However, the rise of natural gas futures trading also puts pressure on natural gas firms to adapt quickly to the changing marketplace. Those firms that undertake a systematic risk audit and implement the strategies, organizational structures, and information systems necessary to manage price risk on a day-to-day basis will succeed. Those firms that fail to adapt will struggle. Only those firms that adapt and incorporate futures as a competitive tool in their arsenal will prosper in the market ahead.