Lower natural gas prices. Businesses want them. But they often forfeit savings because they don’t know where to capture them. One way to reduce cost is to lock in a natural gas price when the commodity price dips. But, natural gas prices comprise more than just the commodity. They also have a “basis” price component. Businesses that can capture the total value of falling natural gas basis prices are on the right track towards top-level natural gas procurement.
However, many businesses don’t capture that value. In other words, they spend more on natural gas than they have to, unable to get the full advantage of natural gas cost reduction opportunities. But they can. This blog post explores lost savings as it relates to natural gas basis prices and variable-price supply deals.
Businesses Have the Choice to Buy Variable-Price Natural Gas Supply
Manufacturers or hospitals in states like Pennsylvania, Ohio, West Virginia, and New York have the option to shop for natural gas supply, stemming from the deregulation of the natural gas utility industry several decades ago. As a result, some businesses buy natural gas from independent suppliers. One reason they do is to save money by securing prices that beat the utilities’. But, others opt to buy natural gas from their local utility company. It’s their choice.
In addition to multiple supplier options, businesses have alternatives regarding how to buy natural gas. Fixed-pricing and variable-pricing are two common ways.
How Variable-Price Natural Gas Deals Differ from Fixed-Price
At a very general level, a typical natural gas supply contract includes a term length, a monthly volume commitment, a delivery point, and a purchase price.
With fixed-price natural gas deals, the buyer and seller negotiate a set purchase price for the contract term. It does not vary from month to month. Suppliers build all of the components associated with the costing and delivery of natural gas to the delivery point (generally, a utility’s “city gate”) into the fixed-price.
On the flip side, the purchase price for variable-price deals is not predetermined, at least in part. It varies from month to month. Generally, it includes a pre-negotiated fixed “basis” price that will be added to or subtracted from the commodity’s monthly expiration price. Usually indexed to the New York Mercantile Exchange (NYMEX), the NYMEX natural gas contract expiration occurs three business days before the first day of the following month. In summary, the commodity price varies by month with the basis price fixed.
For example, if the expiration price for May is $3.000 per million British thermal units (MMBtu), and the contract basis price is $0.250 per MMBtu, then the purchase price for May is the sum of the two or $3.250/MMBtu.
The basis price can be positive or negative, depending on the geographic location of the delivery point.
What is Basis?
“Basis” represents a value differential between a pipeline or regional supply hub and the delivery point. The differential accounts for locational supply and demand fundamentals and pipeline transportation costs. In simplest terms, the tighter the regional supply/demand balance, the higher the basis differential.
For instance, wintertime basis differentials in the Appalachia region are lower than those in New England. In Appalachia, there is an abundance of localized natural gas production and more-than-ample pipeline capacity. Comparatively, New England has less local supply. Therefore, natural gas is sourced from non-local sources, like Appalachia or the Gulf of Mexico, and transported via pipeline to the New England region. And, pipeline capacity in New England is tighter. Hence, higher differentials.
When it comes to variable-price natural gas supply deals, the commodity reference point is generally the Henry Hub (in Louisiana), and the delivery point is the utility city-gate. Utilities receive supply via pipeline at the city gate. Then, utilities transport the gas to consumers through their pipeline distribution networks.
What is NYMEX and The Henry Hub?
Natural gas trading is oriented around the price of natural gas at the Henry Hub. The Henry Hub is an aggregation point for natural gas produced in the Gulf of Mexico and surrounding regions. NYMEX, a commodity trading exchange, posts Henry Hub natural gas prices for future months in the current year (and the next 12 calendar years) every business day; hence, they are “futures” prices.
The commodity reference point for most variable-price natural gas supply contracts is the Henry Hub. But, this does not mean that all gas supplies come from Louisiana. In Ohio, natural gas production is abundant. A great deal of the natural gas consumed in Ohio is Ohio-produced. But, in North Carolina, for instance, local supply is limited. The basis market reflects this. Basis values in Ohio are lower than those in North Carolina.
Like natural gas futures prices, NYMEX posts future basis values for select delivery points across the country.
The Difference Between Basis Costs and Natural Gas Basis Prices
The price agreed to between a natural gas supplier and the consumer is the basis price. The basis cost is the raw value differential between Henry Hub and a city gate. The basis price includes a supplier’s basis cost assumptions, their business cost, margin, and other premiums a supplier builds into a basis price.
Supplier’s basis prices differ given different cost inputs. As a result, some suppliers have lower basis prices while others have higher ones. Consequently, it makes sense for businesses to solicit and compare basis price offers from multiple suppliers.
Businesses Aren’t Getting The Best Natural Gas Basis Prices
When future basis costs decline, businesses can secure lower basis prices. Savings forfeiture happens when consumers do not receive the total value of basis cost erosion. They can lose this value to natural gas suppliers and natural gas brokers.
Businesses are most at risk of forfeting basis price savings in a downward moving basis market.
Proactive suppliers and brokers will attempt to get their customers to execute new variable-price deals by offering lower basis prices for subsequent contract periods. What business wouldn’t want a lower basis price?
But, here’s the problem. Suppliers and brokers may try to increase margins by taking some of the basis cost reduction for themselves. For example, a supplier’s basis cost is $0.300/MMBtu lower, but the supplier offers the consumer a $0.200/MMBtu basis price reduction. In this example, the supplier is attempting to capture $0.100/MMBtu of basis cost erosion. If the consumer doesn’t catch that $0.100/MMBtu, they forfeit savings.
Some suppliers and brokers will push for the close on a new deal by creating a sense of urgency, emphasizing that price reduction opportunities could quickly vanish if the basis market moves upward. While it is true that basis costs could go up, suppliers trying to increase margins may use urgency to stave off businesses from getting lower basis price offers from other suppliers.
Why Manufacturers Need to Shop for Basis Prices
Without competing offers and basis price intel, a business would not be able to discern if their supplier is attempting to increase margin at their expense.
Although it’s possible, future basis market action – particularly for longer-term deals – isn’t typically volatile. Businesses can solicit and receive offers from other suppliers within three or four business days. In other words, a three or four-day timeout to collect proposals from other suppliers is usually worth it.
Natural gas suppliers try to sell basis prices as high as they can to increase profitability. There are other tactics suppliers use to enhance their margins.
A manufacturer can’t capture the total value of basis cost decline when their supplier simultaneously increases its basis price cost inputs. Therefore, they need to shop.
There are many reasons to evaluate offers from multiple suppliers, with basis price savings forfeiture being one. Given the volumes related to natural gas supply transactions, even small per-unit values of lost value can have a meaningful bottom-line impact.
Businesses are Losing Basis Price Savings to Natural Gas Brokers
Natural gas brokers have an incentive to “sell” basis prices as high as possible. Despite inferences otherwise, natural gas brokers are not supplier-paid commissioned agents. Mostly, they are middlemen to natural gas supply transactions. With variable-price natural gas supply deals, brokers build markups into natural gas basis prices. Their compensation stems from the markups. Consequently, brokers can increase profitability at the expense of their customers by taking a large portion of supply price erosion for themselves while hiding the full degree of cost reductions. If you don’t believe me, ask any energy supplier.
Wrapping Up Natural Gas Basis Prices
Basis differentials reflect the delta in value between natural gas supply and delivery points. The differentials, relative to the Henry Hub, are higher in some markets but lower in others. When future basis differentials decline, manufacturers and hospitals can lock in lower basis prices tied to variable-price natural gas supply contracts. But, some businesses don’t capture 100% of the value of falling basis markets because their suppliers or brokers keep part of that value for themselves. However, companies can and should exercise their option to shop for alternative basis price offers to reap the benefits of declining basis differentials fully.
Here’s the question. Is your business missing out on basis price reduction opportunities?