CHAPTER 13 A PRODUCERS PERSPECTIVE ON FUTURES TRADING

• Jurisdiction: United States

Natural Gas Marketing and Transportation
(Sep 1991)
CHAPTER 13
A PRODUCERS PERSPECTIVE ON FUTURES TRADING
Shelley Hurley
Arco Oil and Gas Company
Dallas, Texas

INTRODUCTION

Since April 3, 1990, buyers and sellers of natural gas have been afforded the opportunity to utilize the natural gas futures contract to reduce their firm's exposure to price risk. ARCO Gas, as the marketer of ARCO Oil and Gas Company's 1.9 Bcf/Day of production, in addition to third party supplies, accepts the price risk inherent in the spot and term natural gas markets. Because price risk exposure is an integral part of our day to day operations, ARCO Gas welcomed the NYMEX natural gas futures contract as a means to mitigate exposure to price uncertainty and volatility. Since May 1, 1990, ARCO Gas has been developing risk management and hedging strategies incorporating the NYMEX natural gas futures contract.

Spot Market Price Discovery

With the advent of the spot market in the natural gas industry in the late 1980's, a majority of the natural gas bought and sold was traded during bid week under one month contracts. Prior to April 3, 1990, the price discovery mechanism was tedious at best, and, at worst, short-term. Price discovery was based upon nearby supply and demand considerations with a strong bias towards market psychology. Price discovery was a mysterious number published in industry publications days after the bid week process was completed. A week after trading was completed, buyers and sellers could begin to measure profitability. Price discovery was retrospective, and represented prices for thirty days only. The

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spot price discovery mechanism was less than desirable, but superior to the price discovery mechanism for term, over 30 day, sales arrangements. Term deals initially were entered into on a fixed-price basis. It did not take long for industry participants to discover that one party was generally disenchanted with the price. As a result, a market responsive term market emerged utilizing indexes quoted in industry publications as the basis for the pricing mechanism. Again, the major weakness of this sort of price discovery was that it reflected only a spot, or thirty day, time-frame.

Price Discovery Since April 3, 1990

Since April 3, 1990, the day the NYMEX natural gas futures contract began trading, the natural gas industry was transformed overnight from a myopic thirty day view of prices to a twelve-month future price discovery mechanism. Industry participants could simply look at a screen and obtain an accurate view of what buyers and sellers were paying for natural gas at the NYMEX delivery location at the Henry Hub in Erath, Louisiana. Development of risk management strategies was enhanced by a twelve-month outlook of prices. The factors that effect natural gas prices that may cause wide price swings, i.e., overall supply/demand balances, seasonality of demand, and weather patterns, were more difficult to manage prior to trading of the NYMEX natural gas futures contract. Price volatility was viewed passively, offset only by a combination of fixed price term arrangements, market responsive term arrangements,

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and astute spot trading that required excellent timing in terms of execution of sales. A review of the factors that have had an impact on prices from April 3, 1990 through the expiration of the February, 1991 NYMEX natural gas futures contract, coupled with analysis of price behavior on NYMEX and in the spot market, begins to illustrate why pragmatic applications of the NYMEX futures contract can enhance a firm's profitability.

Price Expectations Versus Reality: June, 1990 — February, 1991

In the third quarter of 1990 conventional wisdom, reported widely in industry publications, was for substantial improvement in gas prices during 1991. First quarter prices were expected to be well over $2.00 and the annual average of monthly spot prices was expected to approach $2.00. These expectations were further fueled by the psychology of the energy markets which followed Iraq's invasion of Kuwait. Prices thus far in 1991 have not met these expectations. This year the factors that have had a negative impact on prices so far are: 1) An earlier than anticipated recession in the fourth quarter of 1990, 2) the fourth warmest fourth quarter since 1895, resulting in low demand for...