Some risks related to the short-term trading of natural gas

Ahmed El Hachemi Mazighi

Abstract Traditionally guided by long-term contracts, the international natural gas trade is experiencing new methods of operating, based on the short term and more flexibility. Today, indeed, the existence of uncommitted quantities of natural gas, combined with gas price discrepancies among different regions of the world, gives room for the expansion of the spot-trading of gas. The main objective of this paper is to discuss three fundamental risks related to the short-term trading of natural gas: volume risk, price risk and infrastructure risk. The defenders of globalisation argue that the transition from the long-term to the short-term trading of natural gas is mainly a question of access to gas reserves, decreasing costs of gas liquefaction, the building of liquefied natural gas (LNG) fleets and regasification facilities and third-party access to the infrastructure. This process needs to be as short as possible, so that the risks related to the transition process will disappear rapidly. On the other hand, the detractors of globalisation put the emphasis on the complexity of the gas value chain and on the fact that eliminating long-term contracts increases the risks inherent to the international natural gas business. In this paper, we try to untangle and assess the risks related to the short-term trading of natural gas. Our main conclusions are listed over the page:

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The author is Advisor on Strategy and Prosepects, SonatrachCommercialisation, Algiers, Algeria.

Abstract continued 1. the short-term trading of gas is far from riskless; 2. volume risk requires stock-building in both consuming and producing countries; 3. price risk, through the high volatility for gas, induces an increase in options prices; and 4. there is no evidence to suggest that money-lenders appetite for financing gas infrastructure projects will continue in a short-term trading system, and this would be a threat to consumers security of supply.

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RADITIONALLY GUIDED by long-term contracts, the international natural gas trade is experiencing new methods of trading, based on the short term and more flexibility. Today, indeed, the existence of uncommitted quantities of natural gas, combined with gas price discrepancies among different regions of the world, gives room for the expansion of the spottrading1 of gas. Even if the relative share of this trade is still very small no more than five per cent of the total international gas trade in 2000, according to Cedigaz statistics (Cedigaz, 2002) we can expect an increase of it in the next decade, mainly because it offers arbitrage windows for both the client and the producer.

The main objective of this paper is to discuss three fundamental risks related to the short-term trading of natural gas: volume risk, price risk and infrastructure risk. The defenders of globalisation argue that the transition from the long-term to the short-term trading of natural gas is mainly a question of access to gas reserves, decreasing costs of gas liquefaction, the building of liquefied natural gas (LNG) fleets and regasification facilities and third-party access to the infrastructure. This process needs to be as short as possible (Stern, 2002, 2003), so that the risks related to the transition process will disappear rapidly. On the other hand, the detractors of globalisation put the emphasis on the complexity of the gas value chain and on the fact that eliminating long-term contracts increases the risks inherent to the international natural gas business (Banks, 2002, 2003). In this paper, we try to untangle and assess the risks related to the short-term trading of natural gas.

1. The long-term trading of natural gas

Until now, the international natural gas trade has been guided by long-term take or pay (TOP) contracts. In these contracts, the producer and the client agree on a programme of gas deliveries, on the duration of this programme, on the price mechanism and on the frequency of renegotiation of prices. Short-term trading includes all transactions in the futures markets, plus spot transactions (Mazighi, 2003b). The first outstanding difference between these two types of trading is that short-term trading is supposed to obey a logic of spatial arbitrages, which is a means of enhancing the integration of the three existing regional gas markets. And the second notable difference is that short-term trading corresponds to a logic of temporal arbitrages, which is a means of developing organised markets and gas-storage facilities. On the whole (Morita, 2003), long-term trading provides security, while short-term trading offers flexibility. Besides this, the main characteristic of long-term TOP contracts is that we have only two fundamental risks: volume risk and price risk. Table 1 depicts the nature and types of these risks, who is exposed to them and the tools or arrangements used to cover these risks. From this table, it appears clearly that we have only two non-covered risks: A2 and B2. The first one exposes the client, while the second exposes the producer, and September 2004
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Table 1 Nature and type of risks for long-term TOP contracts

Nature of risk A. Volume Type of risk A1. Interruption Who is exposed to them? Producer Tools or arrangements The producer buys gas on the shortterm market or swaps gas with other producers, in order to meet his commitments The client takes the gas or pays for it

A2. Committed quantities exceed demand B. Price

Client

B1. Oil price used Producer for indexation is very low B2. Oil price is below producer expectation Producer

The producer fixes a minimum level for the oil price in the indexation mechanism Takes this risk

C. Regulatory

No access to regasification facilities No access to financing tools

Producer

The client is committed to take the gas and to open access to the regasification facilities The TOP contract serves as a mortgage (Morita, 2003)

D. Financial

Both

that is why TOP contracts correspond to an equilibrium situation. 2 In this long-term trade, the risk of no access to financing tools creates a threat to investment and to the security of gas supply. As a consequence, the client and the producer are both exposed to this risk. One interesting thing to note is that, to avoid the interruption risk, the producer needs to have either non-committed gas in excess or the possibility to buy gas on the spot market from other sources. In both cases, it is necessary for the gas supply to exceed the committed quantities. This principle certainly played an important role in the so-called emergence of an abundant gas era (Stern, 2002, 2003). This way of trading necessarily provides security of supply to the client and security of outlet to the producer, which is another proof that the long-term trading of gas corresponds to an equilibrium and to a logic of security. The building of commercial or strategic stocks does not appear to be a necessity, which means that, paradoxically, the long-term trading of natural gas is less costly than short-term trading. However, this way of trading gas which still predominates in the international gas trade has, and continues to receive, several critics. Among the criticisms is the fact that it does not provide enough flexibility, as if flexibility were an end in itself. A second criticism and certainly the most acerbic is that this way of 230
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trading does not correspond to the logic of free trade, which is supposed to be the optimal logic. In reality, the defenders of globalisation overlook the fact that the gas industry is a network industry, where access to the resource can sometimes be more important than a price reduction. Unfortunately, switching from this long-term trading to a pure short-term business will expose both the client and the producer to volume and price risks. Moreover, unless we have a liquid physical market, risks A1 and A2 will require the building of commercial stocks for gas. The price risk will require the emergence of organised markets that offer suitable financial tools, such as futures contracts and options. According to (Mercey, 2003), the financial risk will be more difficult to assess without TOP contracts, lenders appetites for new investment will be reduced and, due to regulatory problems, we could even face disinvestment in the gas midstream (transportation). On the whole, switching from TOP to short-term trading means changing only the governing principles of the international gas trade. All risks will persist, with large uncertainties and different degrees of exposure.

2. Volume risk

Switching to the short-term trading of natural gas, through the principle of arbitrage between places, implies that gas will flow with priority to markets with high prices. Figure 1 depicts the differences in gas spot prices between one of the major United States gas-interconnection systems (Henry Hub) and the main United Kingdom gas-clearing system (national balancing point, NBP). If the gas market was global Figure 1 Spot price differences between the US market (Henry Hub) and the UK market (NBP)

Source: data from various issues of World Gas Intelligence.

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in 200203, gas would have flowed to the US market and the price differences would have certainly decreased rapidly, reducing the attractiveness of the US market. In the short term, one of the consequences of arbitrage between areas is that markets with low prices need stocks of gas (either LNG or underground storage) in order to meet their demand, whereas the satisfaction of this demand was provided through TOP contracts. In other words, commercial stock-building is the first part of the price to be paid by natural gas importers, if they want to limit the recourse to TOP contracts. In this sense, gas consumers have to compare the advantages of arbitrage with the cost of building gas stocks, which means the cost of securing gas supply. The principle of arbitrage does not apply only to gas exporters. Importers of gas, in a free trade system, buy their gas at the cheapest price possible. The other producers have no choice, but to reduce their prices or adjust them to the lowest marginal cost, which, in turn, creates gas competition. In other words, downward pressure on natural gas prices constitutes the first part of the price to be paid by producers, if they are willing to sell-off long-term contracts. In this sense, producers have to compare the opportunities created by inter-area arbitrage with the gas competition effects on prices. Finally, as shown in table 2, short-term trading creates dilemmas for both the consumer and the producer. The only way to remove these dilemmas is to build gasstorage facilities in both producing and consuming countries. Due to the lack of such capacity in gas-importing areas, such as Europe, this will take a long time. In an annex to the European Gas Security Directive (Gas Matters, 2002), we can see that, today, gas-storage capacity in the European Union-15 varies by between only 0 and 31.6 per cent of yearly demand. Moreover, experience from the oil industry has shown that, in order to maintain the same level of days of consumption, the building of storage facilities needs to increase at the same rate as demand. Today, in the power-generation sector which is the main outlet for natural gas the possibilities of the substitution of coal or fuel oil for gas are very large, mainly in the developed countries. As a consequence, the issue of gas-storage facilities does not appear to be a high priority. However, in the coming years, due to the possible entry into force of the Kyoto Protocol,3 and also to the fact that new power plants will use only gas,4 the only substitute for gas will be nuclear, and the issue of gas stocks will be predominant in the energy scene. Table 2 Alternative 1 (short-term trading) More arbitrage in the gas market, but no security of supply More arbitrage, but gas competition risk Alternative 2 (long-term trading) Security of supply, but no flexibility No arbitrage, but no opportunities to pick up

Consumer

Producer

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3. Price risk

Figure 2 compares oil price volatility5 with gas price volatility in futures markets. The ratio between the standard deviation and the mean for the 60 preceding days has a maximum of 0.16 for oil on the New York Mercantile Exchange (NYMEX) and 0.23 for gas on the International Petroleum Exchange (IPE). Figure 2 Volatility of oil prices versus gas prices on a daily basis 31 January 199717 June 2002 standard deviation/mean

Source: data from NYMEX (oil) and IPE (gas). Volatility is defined as the standard deviation divided by the mean of futures contract prices over the past 60 days.

Futures prices for natural gas are obviously more volatile than they are for oil. This volatility discrepancy reflects the degree of uncertainty in the short-term trading of natural gas. Moreover, such a situation can benefit neither the producer nor the client, because volatility increases the price of options used as a hedging tool. Another important characteristic of futures gas prices is that they have a kurtosis of 0.26 and a skewness of 0.91 in the same period, as in figure 2. This means that the probability distribution of gas prices is closer to the probability density of financial speculative products than to a normal probability density. In this sense, trading natural gas, on a short-term basis, cannot correspond to a logic of stable cash flows to the producer. Figure 3 compares the evolution of the prices of Brent, natural gas on the NBP and natural gas indexed to oil.6 In this figure, the minimum oil price level used in the indexation has been set at US $22 per barrel.7 Changing this level can modify the September 2004
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Figure 3 Price evolution of Brent, gas on NBP and gas indexed to oil Weekly basis, March 2003March 2004 (5th of each month)

Source: Petroleum Intelligence Weekly and World Gas Intelligence.

Figure 4 Spot gas price on NBP and gas price indexed to Brent ($20/b and negotiated gas price of $3/mBtu) $/mBtu

Source: Petroleum Intelligence Weekly and World Gas Intelligence.

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smoothing effect of the indexation. However, changing the level of the negotiated gas price cannot affect the general trend of the curve (appendix 1). Through the smoothing effect induced by indexation, the gas price, indexed to oil, seems to reduce the volatility of oil prices and provides more stability than the latter. The standard deviation of the Brent price is $0.4 per million British thermal units, while it is only $0.22/mBtu for the price of gas indexed to oil. The short-term trading of natural gas implies a volatility that exceeds the volatility of oil prices. The evolution of the gas price on the NBP versus the evolution of the gas price indexed to a minimum price of $20/b for North Sea Brent (figure 4) shows that indexation not only reduces the volatility, but also plays the role of stabiliser. Indeed, along the period January 1999December 2003, the gas price indexed to oil never deviates from the level of $3/mBtu, which is exactly what the producer is looking for. Literature on the volatility of commodity prices is very abundant (Mazighi, 2003a). The first question we ask regarding it is whether volatility is something bad and to what extent. In the very short term, efficiency theory tells us that volatility is only the proof that prices are unpredictable, and, as a consequence, speculation is absent. Volatility becomes a problem when it is excessive and when price changes do not fluctuate normally. In a previous paper (Mazighi, 2003a), I have shown that possible inefficiencies occurred on the UK gas market during the period 19992003. Besides the fact that gas price volatility increases the price of options and that it can be a reflection of market inefficiencies, gas producers generally perceive volatility to be a result of price manipulation that does not provide a fair remuneration for their gas. The link that sometimes happens between volatility and the stock level is also worth noting. In this area, the history of oil has shown that no correlation exists in the medium term between stock levels and price levels. However, this can occur in the short term. During the period January 2002February 2003, the price of Brent was negatively correlated to the level of global commercial stocks of crude oil. In the area of power in deregulated markets, the impossibility of storing electricity can also explain the excessive price volatility. So, in order not to have excessive price volatility with the emergence of the short-term trading of natural gas, we need either high levels of gas stocks or excess gas-production capacities.

4. Infrastructure-building risk

Unlike oil, where liquid and flexible markets have been developed during the last 30 years, the development of new LNG chains, which are necessary for the globalisation of the gas business, is very costly, in terms of infrastructure-building. Most often, due to a misunderstanding of the gas business (Banks, 2002, 2003), the risks related to the building of this gas infrastructure are neglected in the literature, even though such risks are highly important. In fact, the security of gas supply is not only a question of having access to gas reserves; the building of the infrastructure from field development to consumer equipment in the residential sector is, without any doubt, the second layer of security of gas supply. September 2004
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However, with the short-term trading of natural gas, the producer loses the guarantee that it can sell its gas; the volumes it can place on the market become uncertain. As a result, in its long-term planning, the producer will be obliged to replace known quantities on the basis of scenarios on demand growth. In other words, certainty is replaced by uncertainty which, given the lack of accuracy of forecasts and the difficulty in accessing capital markets, can reduce the willingness of the producer to invest in infrastructure. One of the lessons learned from the Californian crisis is that investment in capacity is reduced when producers have to face both volume and price risks. A second lesson is that risk-averse producers will only invest in the maintenance of existing capacity, which, when there is demand growth, will create structural disequilibrium and price shocks that are completely out of line with supply security requirements. Another uncertainty is related to investment in the midstream gas sector (transportation) and in the reinforcement of gas interconnections in gas-consuming countries. Indeed, to make the principle of flexibility operate within a particular area, we need a high interconnection rate, so that excess demand and supply can clear rapidly. However, this seems to be very difficult to carry out. In a model of the vertically integrated market, the development of midstream gas was subsidised through the segments of gas sales to eligible and final consumers. Indeed, midstream gas is more capital-intensive than the other segments. The unbundling of the different activities of the gas chain, combined with third-party access and regulation procedures in gas-consuming countries, creates disincentives to invest in the midstream and even disinvestment (Mercey, 2003), due to the relatively low return on this vital segment of the gas chain. On the whole, the short-term trading of gas can be suitable for neither the development of greenfield projects, that are necessary to meet demand growth in the long term, nor the development of the midstream infrastructure. Certainly, long-term contracts will continue to be the norm in the gas industry in the coming years.

5. Concluding remarks

There is no free lunch. Switching from the long-term trading of gas to a shortterm trading system is far from providing only benefits. Moreover, flexibility which is considered to be the main benefit is not an end in itself. From the volume, price and infrastructure risks, one can ask which risk is the most threatening. The price risk paradoxically is not, in my opinion, the most dangerous. In the case where markets are liquid enough, volatility is only a reflection of the fact that markets are operating efficiently, but the unpredictability of prices, that results from this efficiency, obliges the producer and the consumer to have recourse to hedging tools or create stabilisation funds, which is costly. The volume risk requires us to give much attention to the building of storage facilities in the long term, because more and more power plants, in the coming years, will use gas only. The infrastructure-building risk is certainly the most important risk, because it represents a direct threat to the development of new gas chains that are necessary to 236
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meet the long-term increase in natural gas demand. It is worth noting that there is a fundamental paradox between the willingness of developing countries to increase the relative share of natural gas and their intentions to increase the short-term trading of natural gas. In the coming years, TOP contracts will certainly continue to be the norm for the development of greenfield gas projects and recourse to short-term trading will expand, as some long-term TOP contracts reach their expiry dates.

Footnotes
1. In the area of liquefied natural gas (LNG), spot-trading refers to LNG cargoes diverted from their original routes, plus uncommitted LNG sales. In the area of pipeline gas, spottrading refers to the physical side of futures markets. Fundamentally, the main reason take or pay contracts correspond to an equilibrium situation is that they result from a negotiation process where both producers and clients maximise their objective functions. In the case where the Kyoto Protocol comes into operation rapidly, energy prices for the consumer must also reflect the cost of emitting CO2 to the atmosphere. This will give room for the expansion of sources of energy with relatively low CO2 emissions. Natural gas is less carbon-intensive than oil. Power plants that use only natural gas are less expensive than power plants that use coal or two energy sources. Most often, volatility is measured through standard deviations. However, to compare the volatility of several energy sources, we need a non-dimensional measure or percentage. In this paragraph, we have divided the standard deviation by the mean. In the indexation mechanism, producer and client agree on a certain level of price for gas that is periodically renegotiated. This level is called the negotiated price. They also agree on a minimum level for the price of oil used in the indexation mechanism.

2.

3.

4. 5.

6. 7.

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References
Banks, F.E. (2002), Economic theory and the next deregulation blunder: the case of European gas, Geopolitics of Energy, Issue 24, No. 10, October. Banks, F.E. (2003), A perspective on natural gas, OPEC Bulletin, pp.1619, November/December. Cedigaz (2002), Annual Statistics. Gas Matters (2002), November. Hashimoto, T. (2004), The conditions of liquefied natural gas (LNG) contracts attracting users what sort of contracts can be expected?, LNG 14 proceedings, Doha, Qatar, 21 24 March. Mateille, J.P., and F. Barnaud (2004), LNG markets and price volatility, LNG 14 proceedings, Doha, Qatar, 2124 March. Mazighi, A. (2003a), The efficiency of natural gas futures markets, OPEC Review, pp. 143159, June. Mazighi, A. (2003b), An examination of the international trade of natural gas, OPEC Review, pp. 313329, December. Mercey, C. (2003), Is the European gas business becoming riskier for capital providers?, presentation at the Third Executive MEDA Restructuring Energy Companies Seminar, Aix-en-Provence, France, 813 December (MEDA is a group of 12 partner states of the European Union in the south and east of the Mediterranean, including Algeria). Morita, K. (2003), LNG: falling prices and increasing flexibility of supply risk redistribution creates contracts diversity, The Institute of Energy Economics, Japan, April. Stern, J. (2002), Security of European natural gas supplies, presentation at The Royal Institute of International Affairs, London, United Kingdom. Stern, J. (2003), Gas markets in North America, Europe and Asia over the next decade: uncertainties and inter-relationships, presentation at the 25th Oxford Energy Seminar, Oxford, September. World Gas Intelligence, various issues, 19992004.

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Appendix
Insensitivity of the indexation to the level of the gas-negotiated price

Sensitivity of the indexation to the level of oil price

Source: various issues of World Gas Intelligence and Petroleum Intelligence Weekly.

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