Understanding Gas Markets: An Analysis of Purchase, Transportation, and Sales Mechanisms

Abstract

SPE Member Abstract This paper presents an analysis of the natural gas transportation cost mechanisms used by major pipelines for gas moving on the spot market. The paper also presents an analysis of natural gas upstream (purchase) price and downstream (sales) price mechanisms used by gas marketers in the spot market. It is an attempt to document basic algorithms used for determining the transportation component of gas cost and for establishing natural gas prices at both ends of the pipeline. These issues are explored so market potential can be more easily evaluated and gas transactions can be better understood by non-gas marketers. Introduction Scope of Work The paper is taken from a study prepared as part of the software design process for a commercial gas trading system developed to handle all types of spot market transactions. During the initial stages of research, we found that no work had been published which investigated in any kind of analytical way, the common patterns and characteristics of transaction components and their interactions across multiple pipeline corridors. As a result, the transportation practices of most major interstate pipeline companies were studied in detail. These practices included transportation charge mechanisms, transportation contracts, nomination processes, and imbalance management. This paper focuses on the variety of transportation charge (cost) mechanisms used, and groups these approaches into several basic models. The pricing mechanisms used for gas transactions was also studied. Pricing issues include mechanisms for determining purchase prices when buying gas and for determining sales prices when selling gas. Some pricing mechanisms relate sales and purchase prices to each other in various ways, while some schemes are independent of the other prices and costs governing the transaction. This paper documents various pricing approaches and groups them into several fundamental types. A treatment of gas markets would not be complete without a discussion of related issues including gas purchase contracts, gas sales contracts, nominations, and imbalance management. An attempt is also made to define a consistent set of transportation and gas marketing terminology. Words or phrases shown in italics are precisely defined in the text. In some cases, the terminology specified here is different than that found in local industry usage, since different meanings may be expressed by the same term along different pipeline corridors. For clarity, the paper takes the perspective of a market intermediary so the term "purchase" corresponds to the sale of gas for the supply side of an intermediary's business, such as at the wellhead. Similarly "sale" refers to the sale from the market side of an intermediary's business such as to an end user. Structure of Gas Transactions The three fundamental components of gas marketing transactions are the purchase, movement, and sale of natural gas. These components are all complex, each with many possible variations. They are also all interrelated and inter-dependent on one another. Figures 1 and 2 graphically depict this interaction. From a marketer's perspective, gas purchase costs and transportation costs represent the fixed gas cost in a transaction. Gross margins represent the difference between the sales revenue and the fixed costs. (See Figure 2.) Gas marketers' operating costs must be taken from these gross margins as well. Since typical margins are generally from less than one to a few pennies per MMBtu, close attention must be paid to the component costs and sales revenues in order to maximize margins. Since gas supplies and gas markets are often aggregated, and since transportation costs vary for the individual supply-to-market flows which make up these aggregate deals, close financial and operational control of the transaction pools is necessary to maintain profitability. Similarly, for producers selling their gas on the spot market, a thorough understanding of the costs required to move their gas to market is also helpful. Without a fundamental understanding of the transportation and market options in their area, a meaningful economic evaluation of new gas drilling projects can not be undertaken. Furthermore, producers should have a good understanding of gas marketing fundamentals in order to effectively evaluate competing bids for their supplies, since performance as well as price are essential ingredients to a completed transaction. As will be evident after reading this paper, modern gas transactions are surprisingly complex, primarily due to the inclusion of transportation in between the purchase and sale of natural gas. The transportation activity removes a portion of the gas volume through fuel retention which introduces complexity to the description of gas amounts (sometimes referred to as volume accounting terminology). P. 209^