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Marketing

Natural gas marketing is a relatively new addition to the natural

gas industry, beginning in the mid-1980′s. Prior to the

deregulation of the natural gas commodity market and the

introduction of open access for everyone to natural gas pipelines,

there was no role for natural gas marketers. Producers sold to

pipelines, who sold to local distribution companies and other

large volume natural gas users. Local distribution companies sold

the natural gas purchased from the pipelines to retail end users,

including commercial and residential customers. Price regulation

at all levels of this supply chain left no place for others to buy and

sell natural gas. However, with the newly accessible competitive

markets introduced gradually over the past fifteen years, natural

gas marketing has become an integral component of the natural

gas industry. In fact, the first marketers were a direct result of

interstate pipelines attempting to recoup losses associated with long term contracts entered into as a

result of the oversupply problems of the early 1980s. To learn more about the history of natural gas

regulation, click here.

Natural gas marketing may be defined as the selling of natural gas. In even looser terms, marketing can

be referred to as the process of coordinating, at various levels, the business of bringing natural gas from

the wellhead to end-users. The role of natural gas marketers is quite complex, and does not fit exactly

into any one spot in the natural gas supply chain. Marketers may be affiliates of producers, pipelines, and

local utilities, or may be separate business entities unaffiliated with any other players in the natural gas

industry. Marketers, in whatever form, find buyers for natural gas, ensure secure supplies of natural gas in

the market, and provide a pathway for natural gas to reach the end-user. It is natural gas marketers that

ensure a liquid, transparent market exists for natural gas. Marketing natural gas can include all of the

intermediate steps that a particular purchase requires; including arranging transportation, storage,

accounting, and basically any other step required to facilitate the sale of natural gas.

Essentially, marketers are primarily concerned with selling natural gas, either to resellers (other

marketers and distribution companies), or end users. On average, most natural gas can have three to

four separate owners before it actually reaches the end-user. In addition to the buying and selling of

natural gas, marketers use their expertise in financial instruments and markets to both reduce their

exposure to risks inherent to commodities, and earn money through speculating as to future market

movements.

To view statistics related to the selling and marketing of natural gas, including prices and volumes,

click here.

In order to more fully understand the role and function of natural gas marketers, it is helpful to have an

understanding of the basics of natural gas markets.

Natural Gas as a Commodity

Natural gas is sold as a commodity, much like pork bellies, corn, copper, and oil. The basic

characteristic of a commodity is that it is essentially the same product no matter where it is located.

Natural gas, after processing, fits this description. Commodity markets are inherently volatile, meaning

the price of commodities can change often, and at times drastically. Natural gas is no exception; in fact, it

is one of the most volatile commodities currently on the market. The graph below shows the

The price of natural gas is set by market forces;

the buying and selling of the commodity by

market players, based on supply and demand,

determines the average price of natural gas.

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Natural Gas Volatility and Price Levels at Henry

Hub

Source: Energy Inf ormation Administration, Of f ice of Oil and Gas; based on Natural Gas

Monthly publications

Major Natural Gas Market Hubs

Source: Energy Inf ormation Administration

There are two distinct markets for natural gas: the

spot market, and the futures market. Essentially,

the spot market is the daily market, where natural

gas is bought and sold ‘right now’. To get the

price of natural gas on a specific day, it is the

spot market price that is most informative. The

futures market consists of buying and selling

natural gas under contract at least one month,

and up to 36 months, in advance. For example,

under a simplified futures contract, one could

enter into an agreement today, for delivery of the

physical gas in two months. Natural gas futures

are traded on the New York Mercantile

Exchange (NYMEX). Futures contracts are but

one of an increasing number of derivatives

contracts used in commodities markets, and can

be quite complex and difficult to understand. To learn more about futures and other methods of buying,

selling, and trading commodities, click here.

Natural gas is priced and traded at different

locations throughout the country. These

locations, referred to as ‘market hubs’, exist

across the country and are located at the

intersection of major pipeline systems. There

are over 30 major market hubs in the U.S., the

principle of which is known as the Henry Hub,

located in Louisiana. The futures contracts that

are traded on the NYMEX are Henry Hub

contracts, meaning they reflect the price of

natural gas for physical delivery at this hub.

The price at which natural gas trades differs

across the major hubs, depending on the

supply and demand for natural gas at that

particular point. The difference between the

Henry Hub price and another hub is called the

location differential. In addition to market hubs,

other major pricing locations include

‘citygates’. Citygates are the locations at

which distribution companies receive gas from

a pipeline. Citygates at major metropolitan

centers can offer another point at which natural

gas is priced.

Physical and Financial Trading

There are two primary types of natural gas marketing and trading: physical trading and financial trading.

Physical natural gas marketing is the more basic type, which involves buying and selling the physical

commodity. Financial trading, on the other hand, involves derivatives and sophisticated financial

instruments in which the buyer and seller never take physical delivery of the natural gas.

Like all commodity markets, the inherent volatility of the price of natural gas requires the use of financial

derivatives to hedge against the risk of price movement. Buyers and sellers of natural gas hedge using

derivatives to reduce price risk. Speculators, on the other hand, assume greater risk in order to profit off

of changes in the price of natural gas. Some marketers who actively buy and sell in either the physical or

financial markets are referred to as natural gas ‘traders’; trading natural gas on the spot market to earn

as high a return as possible, and trading financial derivatives and other complex contracts to either

hedge risk associated with this physical trading, or speculate about market movements. Most marketing

companies have elaborate trading floors, including televisions and pricing boards providing the traders

with as much market information as possible.

Physical Contracts

Physical trading contracts are negotiated between buyers

and sellers. There exist numerous types of physical

trading contracts, but most share some standard

specifications including specifying the buyer and seller,

the price, the amount of natural gas to be sold (usually
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Trading Floor at a Natural Gas Marketing

Company

Source: NGSA

expressed in a volume per day), the receipt and delivery

point, the tenure of the contract (usually expressed in

number of days, beginning on a specified day), and other

terms and conditions. The special terms and conditions

usually outline such things as the payment dates, quality

specifications for the natural gas to be sold, and any other

specifications agreed to by both parties.

Physical contracts are usually negotiated between buyers

and sellers over the phone. However, electronic bulletin

boards and e-commerce trading sites are allowing more

physical transactions to take place over the internet.

There are three main types of physical trading contracts:

swing contracts, baseload contracts, and firm contracts.

Swing (or ‘interruptible’) contracts are usually short-term contracts, and can be as short as one day and

are usually not longer than a month. Under this type of contract, both the buyer and seller agree that

neither party is obligated to deliver or receive the exact volume specified. These contracts are the most

flexible, and are usually put in place when either the supply of gas from the seller, or the demand for gas

from the buyer, are unreliable.

Baseload contracts are similar to swing contracts. Neither the buyer nor seller is obligated to deliver or

receive the exact volume specified. However, it is agreed that both parties will attempt to deliver or

receive the specified volume, on a ‘best-efforts’ basis. In addition, both parties generally agree not to end

the agreement due to market price movements. Both of these understandings are not legal obligations –

there is no legal recourse for either party if they believe the other party did not make its best effort to fulfill

the agreement – they rely instead on the relationship (both personal and professional) between the buyer

and seller.

Firm contracts are different from swing and baseload contracts in that there is legal recourse available to

either party, should the other party fail to meet its obligations under the agreement. This means that both

parties are legally obligated to either receive or deliver the amount of gas specified in the contract. These

contracts are used primarily when both the supply and demand for the specified amount of natural gas

are unlikely to change or drop off.

The daily spot market for natural gas is active, and trading can occur 24 hours a day, seven days a week.

However, in the natural gas market, the largest volume of trading occurs in the last week of every month.

Known as ‘bid week’, this is when producers are trying to sell their core production and consumers are

trying to buy for their core natural gas needs for the upcoming month. The core natural gas supply or

demand is not expected to change; producers know they will have that much natural gas over the next

month, and consumers know that they will require that much natural gas over the next month. The average

prices set during bid week are commonly the prices used in physical contracts.

The Financial Market

In addition to trading physical natural gas, there is a significant market for natural gas derivatives and

financial instruments in the United States. In fact, it has been estimated that the value of trading that

occurs on the financial market is 10 to 12 times greater than the value of physical natural gas trading.

Derivatives are financial instruments that ‘derive’ their value from an underlying fundamental; in this case

the price of natural gas. Derivatives can range from being quite simple, to being exceedingly complex.

Traditionally, most derivatives are traded on the over-the-counter (OTC) market, which is essentially a

group of market players interested in exchanging certain derivatives among themselves, as opposed to

through a market like the NYMEX. Basic types of derivatives include futures, options, and financial

swaps. To learn more about the basics of derivatives, click here.

There are two possible objectives to trading in financial

natural gas markets: hedging and speculation. Trading in

the physical market involves a certain degree of risk.

Price volatility in the natural gas markets can result in

financial exposure for marketers and other market players

as the price changes over time. Trading financial

derivatives can help to mitigate, or ‘hedge’ this risk. A

hedging strategy is created to reduce the risk of losing

money. Purchasing homeowner’s insurance is a common

hedging activity. Similarly, a marketer who plans on selling

natural gas in the spot market for the next month may be

worried about falling prices, and can use a variety of
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Source: NGSA

Marketers in Action

Source: NGSA

financial instruments to hedge against the possibility of

natural gas being worth less in the future. Countless

strategies exist to hedge against price risk in the natural

gas market, including natural gas futures, derivatives

based on weather conditions to mitigate the risk of

weather affecting the supply of natural gas (and thus its

market price), etc. To learn more about the basics of

hedging in the natural gas market visit the New York Mercantile Exchange here.

Financial natural gas markets may also be used by market participants who wish to speculate about

price movements or related events that may come about in the future. The main difference between

speculation and hedging is that the objective of hedging is to reduce risk, whereas the objective of

speculation is to take on risk in the hope of earning a financial return. Speculators hope to forecast future

events or price movements correctly, and profit through these forecasts using financial derivatives.

Trading in the financial markets for speculative purpose is essentially making an investment in financial

markets tied to natural gas, and financial speculators need not have any vested interest in the buying or

selling of natural gas itself, only in the inherent underlying value that is represented in financial derivatives. While great profits may be made if the expectations of a speculator prove correct, great losses may also

be incurred if these expectations are wrong. While the instruments used for hedging and speculation are

the same, the way in which they are used determines whether or not they in fact reduce, or increase, the

risk of losing money.

Now that some of the basics of the natural gas market have been covered, we can examine the function

of natural gas marketers.

Natural Gas Marketers

Any party who engages in the sale of natural gas can be

termed a marketer, however they are usually specialized

business entities dedicated solely to transacting in the

physical and financial energy markets. It is commonplace

for natural gas marketers to be active in a number of

energy markets, taking advantage of their knowledge of

these markets to diversify their business. Many natural

gas marketers are also involved in the marketing of

electricity, and in certain instances crude oil.

Marketers can be producers of natural gas, pipeline

marketing affiliates, distribution utility marketing affiliates, independent marketers, and large volume

users of natural gas. A recent study of the origins of natural gas marketers found that 27 percent of the

top 30 natural gas marketers in 2000 were entities spun off from interstate pipeline companies. An equal

percentage was made up of entities affiliated with local distribution companies. About 30 percent of the

top natural gas marketers were originally affiliated with producers, and entities formed from large volume

natural gas consumers comprise 6 percent. Finally, independent, newly formed entities represent 10

percent of top natural gas marketers.

Marketing companies, whether affiliated with another member of the natural gas industry or not, can vary

in size and the scope of their operations. Some marketing companies may offer a full range of services,

marketing numerous forms of energy and financial products, while others may be more limited in their

scope. For instance, most marketing firms affiliated with producers do not sell natural gas from third

parties; they are more concerned with selling their own production, and hedging to protect their profit

margin from these sales.

There are basically five different classifications of marketing companies: major nationally integrated

marketers, producer marketers, small geographically focused marketers, aggregators, and brokers.

The major nationally integrated marketers are the ‘big players’, offering a full range of services, and

marketing numerous different products. They operate on a nationwide basis, and have large amounts of

capital to support their trading and marketing operations. Producer marketers are those entities

generally concerned with selling their own natural gas production, or the production of their affiliated

natural gas production company. Smaller marketers target particular geographic areas, and specific

natural gas markets. Many marketing entities affiliated with LDCs are of this type, focusing on marketing

gas for the geographic area in which their affiliated distributor operates. Aggregators generally gather

small volumes from various sources, combine them, and sell the larger volumes for more favorable prices

and terms than would be possible selling the smaller volumes separately. Brokers are a unique class of

marketers in that they never actually take ownership of any natural gas themselves. They simply act as

facilitators, bringing buyers and sellers of natural gas together.
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All marketing companies must have, in addition to the core trading group, significant ‘backroom’

operations. These support staff are responsible for coordinating everything related to the sale and

purchase of physical and financial natural gas; including arranging transportation and storage, posting

completed transactions, billing, accounting, and any other activity that is required to complete the

purchases and sales arranged by the traders. Since marketers generally work with very slim profit

margins, the efficiency and effectiveness of these backroom operations can make a large impact on the

profitability of the entire marketing operation.

In addition to the traders and backroom staff, marketing companies typically have extensive risk

management operations. The risk management team is responsible for ensuring that the traders do not

expose the marketing company to excessive risk. Top-level management is responsible for setting

guidelines and risk limitations for the marketing operations, and it is up to the risk management team to

ensure that traders comply with these directives. Risk management operations are quite complex, and

rely on complex statistical, mathematical, and financial theory to ensure that risk exposure is kept under

control. Most large losses associated with marketing operations occur when risk management policies

are ignored or are not enforced within the company itself.

The marketing of natural gas is an integral part of the natural gas supply chain. Natural gas marketers

ensure that a viable market for natural gas exists at all times. Efficient and effective physical and financial

markets are the only way to ensure that a fair and equitable commodity price, reflective of the supply and

demand for that commodity, is maintained.

To learn more about what factors affect the supply and demand for natural gas, and an overview of

natural gas markets in the United States, click here.

September 20, 2013 by natgas

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