The new cleared CME Group/ICAP Energy contract provides new liquefied natural gas spot market opportunities.
By Drew Wozniak
ICAP Energy LLC.
The rapidly developing liquefied natural gas (LNG) spot market has created a new trading opportunity for international natural gas spreads. Traditionally, the tremendous capital cost of building liquefaction forced LNG producers to lock up long-term contracts. With approximately 10 percent of the world LNG supply available to the spot market, it will be more than 20 percent in 2009, and there are some forecasts that as much as 50 percent will be available in three years. The higher natural gas prices of a year ago allowed lenders to become more comfortable with larger production amounts being dedicated to the spot market. Realizing that this new spot supply had hedging requirements, speculative opportunities and currency requirements, CME Group and ICAP Energy co-designed a National Balancing Point (NBP)/Henry Hub cleared contract. These trades have been done in the past, but they have been cumbersome, potentially combining the efforts of three trading desks, and with temporal transactional risk. After a thorough survey of market participants, a simultaneous least-cost denominator approach was selected and the contract is now cleared through the CME ClearPort service.
Contract Design
The size of the contract is 2,500 million British thermal units (mmBtu), priced in dollars, sized just like the standard cash-settled natural gas swap contract. The NBP leg trades at 1,000 therms a day, a variable dependent on the number of days in a given month. Assuming a 30-day month, this works out to 3,000 mmBtu. This matches up nicely if a market participant decides to leg out of any part of the spread. In addition to the cash-settled swaps, options will be available. Swaps will be both voice and electronically brokered with options being voice brokered only. Over-the-counter electronic trading will be provided through the ICAPture platform, which also has several other natural gas and oil products on it.
The NBP contract, also known as ICE U.K. Natural Gas Futures contract, settles two business days prior to the first calendar day of the delivery month, between 4:00 p.m and 4:15 p.m. London time. Henry Hub contracts terminate and settle three days prior to the last business day of each month. Because the Henry Hub is a far more liquid trading point, the final settlement of the spread contract will be on the days on which Henry Hub contracts settle, but at a different time of day. It will be the volume weighted average price over the same 15-minute interval that the NBP settles. This takes out any event risk from non-coincident settlement. The equivalent time for settlement is 4:00 p.m. to 4:15 p.m. London time, and 11:00 a.m. to 11:15 a.m. Eastern time. The terms offered will be 18 months of bullets, and any strips in combination with the bullets. Eventually bullet months will be added that will make it possible to create maturities as far as three years out the curve. The contract codes are "E2" for the swaps, and "V1" for the options. Daily mark-to-market settlements will use CME foreign exchange (FX) contracts and will settle to the CME British pound futures.
Trade example
Current December NBP: 58.00 pence
Current December Henry Hub: 5.45 USD
- Two counterparties agree to a trade for December 10 contracts at a current contract price of $2.60. Note: The FX outright forward is implied in the spread. i.e. 1.3879 (5.45+2.6)/(58/10)
- Buyer: pays $2.60 and receives the floating price
- Seller: receives $2.60 and pays the floating price
-
NBP settles 35.00 pence
Henry Hub settles 4.50 U.S.
Spot FX fixing is 1.4000 -
Final settlement is $0.40 i.e.
((35.00/10 * 1.4000) - $4.500) -
Buyer pays (2.60-0.40)*2,500 mmBtu*10
contracts= $55,000 -
Seller receives (2.60-0.40)*2,500 mmBtu*10
contract= $55,000
In addition to financially settled swaps, options on the spread will be listed for clearing. Since owning a cargo of LNG at sea is a real option, that option can be valued and placed directly in the financial market with a physical hedge.
Historical characteristics of the spread
There are correlations between hub prices and LNG imports into respective countries. In the United States, LNG is a price taker in most cases, but does at times move above the NBP price.
In addition to the previously mentioned relationship, there are also seasonal patterns where NBP prices have substantially larger winter premiums over the Henry Hub's. The U.S. hurricane season also creates high volatilities that can now be managed with options.
Because LNG is a price maker, in the United Kingdom and continental Europe, or setter at the margin, and LNG tends to be higher priced than domestic pipeline supplies, increased LNG imports tend to widen the NBP/Henry Hub spread. The significant note is that LNG imports tend to lead NBP prices. This can be seen in Figure 2 (Gigawatt Hours LNG is reported here in NBP 30-day moving average).
The Future
The selection of the NBP/Henry Hub spread was a natural choice for the first launch of an international basis contract as there is historical data to perform analysis and understand the performance of the contract, but it is only the beginning. Several Asian indexes are in the process of validation, and other locations are under consideration. But for now, welcome natural gas as a true international commodity.
Drew Wozniak is a Vice President of Market Research and Development at ICAP Energy LLC.
Back to Fall 2009 Issue Home Download a full PDF version of this issue here.
