Simple Physical Natural Gas

Pricing for Both Producer

and Consumer
Peter ONeill is currently Chief Risk
Officer and Head of Finance for Uniper
Global Commodities North America. He
has been involved in energy markets
and risk management for almost 20
years, having worked and held roles in
various multinational energy firms.
Abstract: Despite natural gas being the second largest pri-
mary source of energy consumed in the United States, it
is difficult to find pricing of physical natural gas structures
(fixed pricing, market sensitive pricing, and price stabil-
ity in the form of options) in example format. Physical
products are those whose contracts involve the physical
delivery of the energy. This brief covers equations, pric-
ing, and examples of the primary gas structures from both
the producer and consumer point of view. Examination of
basic pricing equations, day count issues, locational hubs,
structural mechanics (flow and forward curve), weather, and
hedging of deals is presented. This brief is experiential in
nature, allowing the participant to gain from a firm ground-
ing in the simple pricing of physical natural gas structures.

Keywords: backwardation, basis, contango, costless collar,

Leslie McNew is currently Managing
Director of N3Q, MMspire Trading
Company and Executive in Residence
of the Kania School of Management,
University of Scranton. She has
30 years of experience in physical
and financial markets, and has held
senior risk management roles in five
Fortune 500 companies.
dirty hedge, equation, fixed forward price, fixed price,
fixed prices, forward curve, future, gas daily, hedging,
index, inside FERC, location, locational price, market
sensitive, market, mmBtu, option, p hysical natural gas,
price, pricing, quantity, swing swap, time, transportation,
upward sloping
Executive Summary
There are two primary types of natural gas marketing and
trading in the United States: physical natural gas trading
which involves taking delivery of the product and finan-
cial natural gas trading in which delivery of the product
is not the primary objective. In the following brief, we are

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Expert Insights 1
 Simple Physical Natural Gas Pricing for Both Producer and Consumer
concerned with physical natural gas pric-
ing mechanics and assume that delivery is
the primary goal of the deal structure. Gen-
erally, there are three types of pricing sce-
narios in physical natural gas: fixed pricing,
market sensitive pricing, and price stabil-
ity in the form of option usage. This brief
addresses all three pricing scenarios in ex-
amples and discusses hedging scenarios for
the producer and the consumer of physi-
cal natural gas. As we discuss pricing, we
will learn market terms and conventions.
No background material for the physical
natural gas market is presented; this is a
target brief whose main focus is the con-
vention of pricing and a pplication hedging
(dirty hedging, basis hedging, and costless
collars) and the use of diagrams and math-
ematical examples to aid in understanding.
Further, a basic understanding of options
methodology is required. The brief also
touches upon the impact of weather on nat-
ural gas prices.
Basic Pricing Equation
The physical natural gas market is com-
posed of production, transportation, stor-
age, and consumption of natural gas. To
simplify, in this treaty, we will only dis-
cuss physical natural gas deals based on
production and consumption and assume
movement of the physical product along a
pipeline system. The term production or
producer will be further simplified to in-
clude: exploration and development of re-
sources, reserves, and production (drilling,
extraction, gathering) and the midstream
sector of small-diameter pipeline systems
to move and clean gas.
Physical natural gas deals specify the
buyer and seller, the price of the deal, the
amount of natural gas to be sold (usually
expressed in a volume per day), the receipt
or delivery point (the location), and the
tenure of the contract (usually expressed in
number of days, beginning on a specified
day). The notional value of a physical natu-
ral gas deal is presented by Equation 1.
Equation 1: Basic Physical Natural Gas
Pricing Equation
2 Expert Insights
Dollar size of a deal = T Q P
The concepts of T (time) and Q (quantity)
remain relatively consistent throughout
the discussions of (P) fixed pricing, market
sensitive pricing, and price stability in the
physical natural gas market. We will discuss
these concepts first.
Time
Because physical natural gas is actually
flowed (moved along a pipeline from
point A to point B), time is a very impor-
tant component of the price of the deal. If
we were just like trading stock, we would
price a simple stock deal at P Q (the price
of the stock times the number of shares of
the stock we wish to buy). This is the price
of the stock deal regardless of how long we
hold onto the deal. However, in physical
natural gas, time is important as the price
of the deal is dependent on how long the
deal takes in days: we need an exact day
count.
T = time, specifically the day count of
the deal. The exact day count is very im-
portant in managing the price of a natural
gas deal. For example, not every month
has the same day count. If we were to
flow a natural gas deal across the month of
September, we would be using a 30-day
count. However, if the deal were to flow
across the month of October, we would be
using a 31-day count. It is best to remem-
ber the old childhood rhyme: 30 days has
September, April, June, and November. All
the rest have 31, except February which
has 28 or 29 in Leap Year.
Table 1 is a simple physical natural
gas deal flowed through a 30-day-count
month.
Similarly, we can check this deals dollar
value by calculating the physical natural gas
each day of the month, and then summing
Table 1: Equation 1 with Pricing Data on a
30-Day Month
Dollar Size of Deal 5 Time Price Quantity
$ 1,284,255.00 30 $ 3.50 12,231
 Simple Physical Natural Gas Pricing for Both Producer and Consumer

Table 2: Pricing Out a Physical Natural Gas Table 3: Using the Correct Monthly Day
Deal Each Day of a 30-Day Month Count
Days of Price Dollar Size
Month Per Day Quantity of Deal 5 Time Price Quantity
1 $ 3.50 12,231 $ 42,808.50 $ 1,284,255.00 30 $ 3.50 12,231
2 $ 3.50 12,231 $ 42,808.50 $ 1,327,063.50 31 $ 3.50 12,231
3 $ 3.50 12,231 $ 42,808.50 $ (42,808.50) incorrect notional pricing
due to loss of 1-day
4 $ 3.50 12,231 $ 42,808.50 revenue
5 $ 3.50 12,231 $ 42,808.50
6 $ 3.50 12,231 $ 42,808.50
It is important to note that we must pay
7 $ 3.50 12,231 $ 42,808.50 particular care to the actual day count in
8 $ 3.50 12,231 $ 42,808.50 the month. Using an incorrect day count
9 $ 3.50 12,231 $ 42,808.50 can lead to incorrect pricing of a deal. See
Table 3.
10 $ 3.50 12,231 $ 42,808.50
11 $ 3.50 12,231 $ 42,808.50 Quantity
12 $ 3.50 12,231 $ 42,808.50 Q = quantity size of the deal in mmBtu.
13 $ 3.50 12,231 $ 42,808.50 Natural gas trades via a quantity in mmBtu.
14 $ 3.50 12,231 $ 42,808.50 One mmBtu equals 1,000,000 British ther-
mal units (Btu). One Btu is the heat neces-
15 $ 3.50 12,231 $ 42,808.50
sary to raise the temperature of 1 pound
16 $ 3.50 12,231 $ 42,808.50 of water by 1 degree Fahrenheit. Roughly
17 $ 3.50 12,231 $ 42,808.50 1,000 cubic feet of natural gas is 1 mmBtu.
18 $ 3.50 12,231 $ 42,808.50 For example, if one wooden kitchen match
is lit, it produces 1 Btu of energy.
19 $ 3.50 12,231 $ 42,808.50
20 $ 3.50 12,231 $ 42,808.50 Fixed Prices
21 $ 3.50 12,231 $ 42,808.50 The deal in Table 1 can be described as
22 $ 3.50 12,231 $ 42,808.50 a fixed forward deal (sometimes known as
23 $ 3.50 12,231 $ 42,808.50 a forward contract or a fixed price physi-
cal contract). This deal is a legal agreement
24 $ 3.50 12,231 $ 42,808.50
between two parties to buy/sell physical
25 $ 3.50 12,231 $ 42,808.50 natural gas at a specific price, a specific
26 $ 3.50 12,231 $ 42,808.50 location, and at some specific time in the
27 $ 3.50 12,231 $ 42,808.50 future. The specifics are agreed upon when
the deal is struck. Diagram 1 illustrates a
28 $ 3.50 12,231 $ 42,808.50
simple 30-day fixed price deal. The terms
29 $ 3.50 12,231 $ 42,808.50 of the deal are agreed upon today, but the
30 $ 3.50 12,231 $ 42,808.50 deal (the flow of physical natural gas) will
$ 1,284,255.00 not start until sometime in the future, and
will continue flowing until the agreed-
up the daily price of the natural gas at the upon tenor of the deal. The flow of natural
end of the proposed month. Table 2 is a 30- gas can also be agreed upon to flow tomor-
day month with natural gas flowing each row or next month. The agreement is bind-
calendar day (therefore, in the equation, the ing but flexible in the negotiation phase. It
day count on each day = 1; P Q 1) with is an over-the-counter (OTC) contract.
the deal dollar amount summed up at the Physical natural gas may be traded in
end of the proposed month. various time blocks: 1 day, balance of
Expert Insights 3