Natural Gas & Crude Oil - Physical Pricing

In a previous lesson, we talked about the financial markets for crude oil and natural gas. And keep in mind, those are future markets. They're telling us what the prices are every day for months going forward. But what about what's happening each day? And what about the trading for the actual physical commodity where the financial markets aren't even involved?

We're going to talk about how those things are priced. And we're going to talk about some key publications that come out that actually show the results of all the trading in the physical marketplace. And then, the market uses those as price discovery. We talked about the fact before that the New York Mercantile Exchange provides price discovery for future months for crude oil and natural gas.

In terms of the natural gas industry itself, actually, both industries were heavily regulated over the years. And we've seen deregulation occur across the board in several industries-- the airline industry used to be regulated. The banking industry was regulated. The telecommunications industry was regulated.

And so, both crude oil and natural gas had been regulated. From the natural gas standpoint, the utilities and the pipelines were regulated. And then, from the crude oil standpoint, the pipeline industry itself was regulated. The idea in both those cases was to basically make sure there wasn't a monopoly, that no one had excessive market power that would hurt the market participants, especially the consumers.

So, generally speaking, way back, there were long-term contracts entered into, mostly by producers and pipelines for natural gas or utilities. These prices were fixed prices. That means they agreed upon a fixed price for the duration of that contract. Now, back in 1978, the Carter administration enacted what's known as the Natural Gas Policy Act. There was concern-- in fact, the Department of Energy back then predicted that the United States would run out of natural gas by the year 2000. Obviously, that was not the case.

But what they did was, they set prices for natural gas. They had a starting price. And then, every month, the price would go up by a few cents per MCF. Now, obviously, this was not market responsive. In other words, if you were producing, you were guaranteed a price, and you were guaranteed that price will go up every month. So, this is what led to the bubble that we had in the early '80s, and then the subsequent crash in natural gas pricing as producers decided just to go out and drill and produce as much as they could at these fixed prices. And the pipelines and utilities had to take the gas because they had these long-term commitments.

Finally, in January of 1985, those price controls of the NGPA had expired. This began what we call the beginning of the spot market. In other words, you would have these long-term arrangements where pipelines and utilities were buying gas from producers. And now, they didn't need as much gas as they were obligated to purchase. The federal government allowed them to get out of those contracts, but they had to open up their pipelines to allow others to use the services on the pipeline.

So, the surplus supplies led to the advent of the marketing companies that we still have today. The marketplace then turned to shorter-term contracts and shorter pricing periods. You could now negotiate prices for natural gas on a monthly, and even a daily basis, and these were more market responsive. In other words, when producers had extra gas to sell, they would contact a potential buyer. And that buyer would look at the demand picture. And then, conversely, if buyers were out there and they needed additional gas, they would contact producers and suppliers.

And so you had more of a sense, truly, of supply and demand as opposed to just some long-term commitment to buy or sell. But again, pre-NYMEX-- in other words, pre-April of 1990 for natural gas, there was no price discovery. People would negotiate transactions over the phone and hope that the price turned out to be a good one. And then, they would rely on these publications that we're going to talk about to see where prices actually came out.

Now, in the case of crude oil, I think as we all know, this is a very, very old business. Refiners and producers used to enter into long-term contracts. These were fixed prices. And then, back-- way back, the railroads and pipelines themselves were regulated by the federal government. Again, this idea of the fear of monopoly. Initially, it was the Interstate Commerce Commission, which was later rolled into the Federal Energy Regulatory Commission, which has jurisdiction over railroads and pipelines. Again, those that cross over state lines, or what is known as interstate.

Crude oil pricing, again, the same situation with natural gas. Prior to the advent of the NYMEX contract for crude oil in 1983, there was no price discovery. And so, negotiations would go back and forth, and prices would probably change with almost every phone call.

Now, today, we've got global market pricing. These are known as markers-- key markers around the globe, where people look at the prices that are being traded at those major hubs. Of course, we have WTI here in the United States at the Cushing Hub. And then Brent, that's the North Sea crude oil pricing. And then in the Middle East, you have the Dubai/Oman price index as well.

Now, crude oil is different from natural gas in that the contracts are negotiated at a certain price or certain marker, but then, there can be price adjustments based on the specific gravity of the crude oil, the sulfur content-- is it sour or is it sweet like WTI-- and then what's known as the Reid vapor pressure, and that's essentially the propensity for it to turn to vapor. You actually lose some energy content when it does that. So, the contracts will have that.

Whereas, in a natural gas marketplace, all the gas has to meet the pipeline specifications. So, you can't have certain contaminants or high content of oxygen, nitrogen, and those types of things. So, there's pretty much a standard to the contracts for physical and natural gas in the cash marketplace. They don't have to make deductions for those quality specifications.

Now, the methods for establishing price, as we talked about and as Errera mentions, both NYMEX and cash can influence one another. For instance, if cash prices tick up due to high demand in a cold winter or hot summer, then those trading the NYMEX contracts are going to get that information. And they're going to essentially assimilate it and then buy contracts accordingly.

And then, the converse is also true. If the cash marketplace, let's say, for instance, in a particularly a shoulder month or if the cash marketplace is trying to determine what prices might be for the following winter, they're going to look to the New York Mercantile Exchange for price discovery and price indications. So, again, the idea that both financial and physical prices tend to track one another in parallelism and the fact that they tend to match one another upon the settlement of the futures contract, or convergence, means that they both can influence either in the prices themselves.

What we have are, though, we've got major publications that we'll talk about. And what they do is they have polling or survey methodology. In a lot of cases, they'll actually call markets and suppliers to find out what types of trades that they have conducted in the physical marketplace.

These days, it's probably more than likely that the information is being emailed to the publication or faxed to the publication. And when the publishers get that information, they have to establish what we call a weighted average cost of gas, or WACOG, or a weighted average sales price, or WASP. That means that they're taking, say, for instance, natural gas.

If there was 5,000 MMBtus, they trade it at $2.50. And then another supplier reports that there's 10,000 MMBtus. They traded it to $2.55. You can't just take the simple average. OK. They actually weight those.

And then, what happens is they post the prices. That's the term that we use. That means they put a publication out, and they actually have the prices there. And then, we refer to them as indexes or postings. Generally, in things like the crude oil and natural gas liquids, they do use the term postings. On the natural gas side, they tend to use the word index.

And generally, what you'll see on under the postings is the actual location, which is important. It's the physical location where either natural gas or crude oil is changing hands. They'll show the volume, the total volume traded at that location for that period of time that they're reporting it. It could be monthly. It could be a daily time period.

And, of course, the price range. In other words, what was the range of pricing at that location that was reported by the people who turned the pricing information in to the publications? And then, finally, the piece of information that we're interested is the actual index. What was that weighted average price at that location?

In the natural gas industry, we've got some publications. Again, we refer to these as indexes. And they'll conduct surveys for monthly, weekly, and even daily pricing.

We've talked about this idea that especially the power industry ramps up and ramps down every day, even peak, off peak. There's times when the power plants may generate up for a few hours and then back down again. So, we have a daily market. And, again, they're talking to end users, producers, and even marketing companies who are buying and selling natural gas to get the information from them.

One of the key ones is Platts. It's a Mcgraw-Hill company. And they produce what they call their monthly price guide.

Now, this is more familiarly known as Inside FERC because, initially, this was a newsletter that reported on the things that were going on at the Federal Energy Regulatory Commission. It is not affiliated with FERC. But those who have been in the industry a long time, especially traders, will refer to the Inside FERC index. But it is more formally known as Platts Monthly Price Guide.

Now, this is the most widely used monthly price guide. It's a bi-monthly newsletter and price report. What they're reporting on is transactions that have taken place for an entire month. So, for instance, at the end of May, as an example, the various entities in the natural gas business are buying and selling gas for June. And when the Inside FERC publication comes out after they've assimilated all the information-- it usually comes out about the second or third working day of the following month-- people will see what the indexes are.

Now, another one that Platts puts out is what's known as Gas Daily. This is a daily price guide. OK. They actually show prices as well for monthly transactions, but they're not as widely used as Inside FERC for those. More importantly, they're used for daily and weekly prices.

OK. This is the most widely used report for daily natural gas pricing, especially what we call swing. In other words, as supply and demand change from day to day, transactions and pricing will move up or down. And then, Platts gets survey information and posts it out there every business day.

In terms of the crude and natural gas liquids industry, the common-- excuse me-- the most important publications there and therefore the most important postings are going to come from generally two sources. One is what's known as OPIS. It's the Oil Price Information Service.

This is for natural gas liquids. They put out the monthly and daily negotiated pricing. They have a market overview; no, it's a commentary. And then they report prices at the major natural gas liquids hubs around North America.

Now, ARGUS. ARGUS is primarily known for crude oil pricing and refined products pricing, things like gasoline, jet fuel, et cetera. They put out monthly pricing, daily pricing. Now, they have a market overview. And then, they give major hub reports. In their case, though, in addition to giving major hub reports around in North America, they give prices for various global oil markers, not just WTI, Brent’s, and Dubai Oman, but various other marker prices around the world.

And then, I want to talk for a minute about electronic platforms. The Intercontinental Exchange. They're based out of Atlanta, Georgia. They also own ICE Futures Europe, which used to be the international petroleum exchange in London.

At the end of every day, they have settlement prices that are automatically calculated. In other words, they're calculating all the trades that occurred electronically on their system. In other words, it's not manually done. The weighted average cost and the weighted average sales prices are calculated.

Now, they handle thousands of physical and financial products. And it's anonymous counterparty trading. In other words, when you buy or sell on ICE, you're just looking at prices. And if you execute a trade, then you'll get a pop-up window that tells you who the counterparty is that you just transacted that with.

ICE themselves, they're strictly a broker. That is, all they're doing is getting a minor commission for providing the platform out there for counterparties to trade. And then they, again, they put out their daily postings where everything gets settled. And you can go out there and look and see.

For instance, you can find a natural gas hub and see what the average price was for all the trades that occurred on the Intercontinental Exchange. Now, one of the big advantages is this is not human beings reporting prices. This is a machine in essence spitting out actual transactions that occurred. So, there's no price fixing possible, and there's no erroneous prices being reported to the publications.

The natural gas industry especially went through a period in the early 2000s where there was in fact price fixing, false reports-- excuse me-- false prices were reported to publications, which influenced pricing. As a result, the Commodity Futures Trading Commission along with the SEC did investigations. There were natural gas traders who were fined and even got some jail time for doing that.

So really, the ICE prices to me would be the most transparent and the most honest, so to speak. And it should be utilized. And really, some of these other publications should go away because they're-- to me, they're relying on human pricing.