Knowledge Base

Natural Gas as a Commodity

Webster's defines a hydrocarbon as "an organic compound containing only carbon and hydrogen". Natural gas is a mixture of hydrocarbons, the precise composition of which varies, which generally consists primarily of Methane (CH4) along with smaller amounts of Ethane (C2H6), Propane (C3H8), Butane (C4H10) and other heavier hydrocarbons as well as contaminant elements (such as water, nitrogen, and others). The specific concentration of elements and contaminants vary by geological source but Methane is always the principal component (generally accounting for 70% to 95%).Webster's defines a commodity as "a good or service whose wide availability typically leads to smaller profit margins and diminishes the importance of factors other than price".To be considered a commodity, a good or service must generally meet three tests:

1. There must be a large number of buyers and sellers.

There are many buyers and sellers of natural gas, including:

  • Producers: extracting natural gas from the ground, producers have a reasonably known (albeit declining) forecast of their production
  • Wholesalers: buying and selling in large quantities, wholesalers serve as the middlemen of the market, providing liquidity to markets by serving as a ready taker and provider of large volumes. Some wholesalers may even serve as market makers, willing to buy and sell at the same location for the same delivery period.
  • Financials: banks, hedge funds, or large private investors participate in the natural gas market for profit and as a means of providing structured derivative contracts to their customers. Some financials may serve as market makers, willing to buy and sell at the same location for the same delivery period.
  • Gas Utilities: often referred to as Local Distribution Companies (or LDCs), these regulated utilities deliver natural gas to consumers (e.g. your home) within a defined geographic area.
  • Retailers: in competitive retail markets (in which consumers may buy their natural gas from a variety of providers), retailers function similarly to gas utilities.
  • Generators: in 2016, natural gas-fired generation surpassed coal to become the leading generation fuel, used to generate a little more than one third of US power utilities' generation.
  • End Users / Industrials: beyond its use as a fuel for industrials, natural gas can be used as an ingredient in the production of plastics, chemicals, and much more. In the US, industrials accounted for over 40% of natural gas usage in 2016.

2. There must be a forward market -- a desire by market participants to buy or sell for future delivery.

Many of these market players will need natural gas on an ongoing basis. And, as storage capacity is limited, they arrange to buy and sell their natural gas for future delivery. For example, a natural gas utility or large industrial doesn't wait to arrange for their natural gas supplies but rather contracts in advance to ensure their access to supply and lock down operating costs. Moreover, they enter into these forward contracts with a number of suppliers to reduce their supply risk should any one supplier not be able to perform. Likewise, producers and wholesalers prefer to arrange for delivery of natural gas on an ongoing basis to ensure they have a market for their supply.

3. The good or service must be fungible, such that one seller's good or service is indistinguishable from another seller's good or service.

The fungibility issue is met, albeit a bit less straightforwardly. Natural gas quality can vary by pipeline. Actually, "quality" is defined by each pipeline within their tariff (Tariffs are documents filed with regulators detailing the pipeline's terms and conditions of service and associated prices for various customer classes). Each pipeline's definition of quality varies based on the geographic areas in which they are situated since the pipelines were designed for the gas they would transport. Each pipeline needs the source natural gas they transport to remain gaseous at the pipeline's typical operating pressure and temperature. The inclusion of lower quality gas (e.g. containing additional heavy hydrocarbons, etc.) may cause components in the gas to liquify, reducing a pipeline's performance and life. As such, the FERC leaves it to the pipelines to define quality with the FERC addressing quality disputes on a case by case basis. Even still, "pipeline quality" gas can generally be defined as natural gas in the range of 99.5% to 100.5% of the BTU of pure methane which is reasonably free of contaminants. As such, issues of quality, and even interchangeability between pipelines, are relatively rare in the US. However, this need not always be the case. Issues became much more common in 2006 when a spike in natural gas prices without a concomitant rise in the price of related hydrocarbons led producers to leave the heavier hydrocarbons in their gas rather than process them out for separate sale (an issue which resolved itself when shale extraction brought down the price for natural gas).

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