U.S. GAS MARKET ADAPTING TO COMMODITIZATION; ELECTRICITY LIKELY TO FOLLOW SIMILAR COURSE

David Pruner
KCS Energy Risk Management Inc.
Edison, N.J.

With the final implementation of Federal Energy Regulatory Commission Order 636 in 1994, the U.S. natural gas industry fully entered the third phase of an evolution from regulation to deregulation and, finally, commoditization.

Now, the only major segment of the natural gas industry left to fully deregulate is that of local distribution companies behind the city gate with smaller customers. A model for that type of deregulation exists in Canada, where in the Province of Ontario homeowners can choose from whom to buy gas. Other industries, such as long-distance telephone service and airlines, have recently gone through this evolution.

Signs of commoditization in the U.S. and Canada were appearing in the 1980s and have become clear in the 1990s. They include:

Growing volatility of prices. Fig. 1 (25930 bytes) shows how variable prices have become over relatively short periods at the wellhead in the U.S. and at the Empress hub on the border of Alberta and Saskatchewan in Canada. In Fig. 2 (30210 bytes), the volatility of natural gas prices is compared with that of prices of other important commodities.
The emergence of an important role for short term contracts in markets where long term contracts once ruled. This is reflected in the growth in importance of the spot market in the U.S. and, later, Canada (Fig. 3) (33074 bytes).
Development of the ability to effect gas sales as either physical or financial and service transactions and of products and markets to handle them (Fig. 4). (23418 bytes)

The effect of commoditization is similar to that of Order 636, which unbundled the transportation and sales services of U.S. interstate gas transmission pipelines. Commoditization has unbundled the risks inherent to the gas industry.

Today, a company can use hedge tables to help address each of these risks. A simple gas transaction involves risks of credit, price, basis (divergence between gas values in different markets), transportation, volumes, and foreign exchange. Hedge tools are available for each type, as shown in Table 1. (15900 bytes)

DEREGULATION AND NOW

Commoditization has broken down the barriers of entry to the natural gas industry.

New players have come into the market, increasing competition and reducing margins. This has made it difficult for one company to differentiate its gas molecules from those of another; the market, in other words, has become more homogeneous than before.

In response, sellers have tried to raise their margins from the current level of 1-4/MMBTU by creating and offering new products and services.

For example, marketers now offer what are called packaged products, which combine physical gas with a financial instrument and allow producers to limit their exposures to harmful price moves. Packaged producers were not requested by the consumers of natural gas but rather created by sellers of gas in an effort to restore margins to levels of earlier days.

This has brought in a new group of competitors, the commercial and investment banks. And it has created a new entity, the trading company. These new entrants all are well-capitalized, sophisticated in the financial markets, and experienced in dealing with risk.

As in other maturing industries, they have brought to the forefront the issue of credit. As this issue continues to increase in importance, only the companies that have strong balance sheets or hard assets will be able to survive the transitions now under way.

INCREASED RISKS

For producers, gas market changes have raised not only risks but also potential rewards. But this means producers must learn to deal with a more complex market and deal with many more choices.

Some producers do not want all the new choices that have come into existence and would prefer that the market revert to its previous state.

This creates an opportunity for marketers willing to rebundle services and explains why packaged products, which 2 years ago were considered specialty items, are today standard fare. And without producers' demand for such products, marketers would not be able to sustainably expand their market shares and, except for niche marketers, would have trouble maintaining current shares over the long run.

The many risk management tools now available to producers have largely replaced the long term, fixed price contract of the industry's earlier years.

Local distribution companies (LDCs) have not had comparable access to these tools. Regulatory problems limit their use of financial instruments. In most states, all hedging gains go to ratepayers and all losses to shareholders. A few large state or provincially regulated LDCs in North America have received approval for pilot hedging programs, which differ in methods and goals (Table 2). (28947 bytes)

As long as these disparities remain between access of LDC gas buyers and producer sellers to risk management tools, comparisons will be difficult. A few generalizations about producer use of these tools are possible, however.

Producers are prone to risk and therefore seldom completely hedge price risk. On average, most producers hedge between 40-60% of their price risk with 80% usually being the maximum.

There are exceptions. Producer affiliates of LDCs and private companies that want to convert production into an annuity payment sometimes hedge all their production. Many public producers, especially independents, feel that companies invest in them for a price and therefore hedge no more than 20% of their exposure, if at all.

RISK MANAGEMENT STEPS

Producers tend to begin risk-management programs with blind hedging. In this strategy, the producer puts a hedge in place and doesn't touch it until the physical risk being hedged goes away, such as when the production is sold.

A hazard in blind hedging is what is known as the producer's paradox: Hedging some production then welcoming a market slump, which validates the hedging strategy but creates losses on unhedged production that offset gains from the hedge.

The next step is dynamic hedging, in which the producer establishes a hedge but adjusts the percentage of production hedged based on changes in the market. This is much more sophisticated than blind hedging and requires discipline, good procedures, and controls. Without these extra steps, dynamic hedging can become speculation and expose the company to great loss.

In a market as volatile as natural gas, producers should hedge in accordance with a well-defined strategy with clear rules and avoid making decisions at market extremes. At those times, it is difficult to remain objective and costly to be wrong.

Physical packaged products have become popular because they allow for one-stop shopping; a producer can sell gas and obtain risk management tools at the same time.

The most common products in this category are trigger or to-be-priced contracts, in which the producer can establish a sales contract for 1 month or many years yet choose to fix the price for the entire contract or selected months at a later date. Such a contract becomes in index contract-that is, the price for gas sold under it reverts to some published index price-if the producer does not fix the price during the allotted time.

Another common packaged product, especially since the gas price doldrums of 1994, is the floor contract. In this case, the producer's price floats from month to month but never falls below a preset level. Producers reluctant to lock in prices tend to favor floor contracts.

Other physical products or services can hedge price risk from storage to capacity release, services now marketed and priced separately under Order 636.

FINANCIAL INSTRUMENTS

After packaged products, the next natural move up the ladder of hedging strategies for producers is to the use of financial instruments.

Here the producer must choose between over-the-counter (OTC) instruments, such as swaps and OTC options, and exchange-traded instruments, such as futures and options. The choice depends on whether the producer wants to take a tailored or generic approach to hedging.

OTC instruments allow for customization of key elements such as timing, price location, and volume. But they are generally more expensive than the standardized contracts traded on exchanges. An OTC instrument is more difficult to sell than exchange-traded contracts, which, lacking customization, have more-liquid secondary markets but don't always match the risk to be hedged.

OTC products also carry greater risk than exchange products because the credit risk a producer faces is that of the other party to the transaction.

When they choose OTC hedging instruments, therefore, producers must pay special attention to credit-worthiness of others in the deal. For contracts traded on exchanges, the exchange itself backs the credit.

The most common OTC instruments are swaps and options. Because swaps lock in prices by exchanging cash flows based on a fixed reference price and floating market price, many producers have come to prefer options. A producer pays a premium for the option and receives the right, but not the obligation, to buy or sell gas at a certain price. This leaves the producer with the potential to gain from a favorable move in gas prices.

Options can be blended with swaps into what are known as "exotics." The most common of these is the participating swap, which enables the producer to lock in a price but receive a percentage of the gain from a favorable price move.

Another type of exotic is the extendable swap. The producer receives an above-market price in the current year, but the seller has the right to extend the swap for another year. Exotics are gaining popularity among U.S. producers and just beginning to gain acceptance in Canada.

Much more-exotic structures can be created to enable a producer to perfectly hedge almost any risk-for a price. Like limited-edition automobiles, however, these instruments become difficult to value and have very limited secondary markets.

Following OTC instruments, producers move on to exchange-traded futures and options, which generally are much more liquid-meaning easier to buy and sell. Producers must be aware of the potential for daily changes in margin requirements-financial backing requirements set by exchanges to ensure traders can cover their positions.

Recently, swap dealers have become increasingly strict with margin requirements not only on OTC deals but in physical transactions as well. hi some cases during the current gas price slump, credit-worthy traders have had to post steep margins. Producers should assure that all measures to their swap agreements are reciprocal between buyer and seller.

Producers that hedge with futures must stay abreast of the values of their positions, which in times of tightening margin requirements can produce unexpected calls for cash.

ELECTRICITY DEREGULATION

The deregulation process that began in the 1970s for natural gas and culminated with Order 636 is being repeated in the electricity industry.

The industries are similar in many ways but different in many ways as well.

The electricity industry is one of the last major industries in the U.S. to be deregulated. With assets of $185 billion, it is more than twice as large as the natural gas industry, encompassing 3,000 utility companies in the U.S. vs. 300 gas LDCS.

Deregulation and commoditization will create opportunities for companies to correct and capitalize on the inefficiencies that now exist. To date, FERC has received more than 80 filings from companies wanting to become power marketers.

The New York Mercantile Exchange plans to launch an electricity futures contract this year. The contract will develop differently from the gas futures contract, which didn't come into being until after the commodity had been deregulated and which was preceded by an active spot market.

Delivery points for the electricity contract at present are the California-Oregon border (COB) and Palo Verde, Ariz. The electricity market might mature rapidly. Many institutions are poised to become involved in it, and many of them are financially strong, highly sophisticated, and skilled in dealing with risk.

Plans for electricity deregulation remain unclear, but the regulatory steps followed by natural gas probably will set the pattern.

One certainty for the natural gas and electricity industries is price volatility, which will increase until all parts of the industry are deregulated and fully adapted to commodity trading.

For natural gas, completion of the commoditization phase should come about the end of the decade. Producers will have to deal with the volatility or otherwise prepare for a very uncertain future.

THE AUTHOR

David Pruner is president of KCS Energy Risk Management Inc., a subsidiary of KCS Energy Inc. He earlier was chief operating officer of KCS Energy Marketing, formerly Energy Marketing Exchange Inc., KCS Energy's gas marketing subsidiary. A graduate of Southern Methodist University, Pruner serves on marketing and natural gas advisory committees of the New York Mercantile Exchange.