The largest component of price risk is the underlying price of natural gas. In the US natural gas markets, this risk is mitigated through natural gas futures contracts. Webster defines a futures contract as “a contract purchased or sold on an exchange in which a party agrees to buy or sell a quantity of a commodity on a specified future date at a set price”. Futures contracts are offered by calendar month for up to ten years into the future, allowing parties to exchange a floating price for a fixed price. The standardized NYMEX contract is for 10,000 MMBtu of natural gas per day (for a full calendar month) for delivery at the Henry Hub in south Louisiana. ICE offers natural gas futures contracts as well, but all priced off the associated NYMEX future contract settlement and therefore priced for delivery at the Henry Hub.
The Henry Hub is a very liquid trading point in south Louisiana and is considered the de facto market price for natural gas in the US. Physical commodity futures contracts must be standardized, including a defined delivery point. The NYMEX considered many factors when selecting their physical delivery point, including competitive access (diversity of supply/demand), operational stability (minimize outages), and sufficient liquidity to serve as a spot market. The NYMEX began offering their natural gas futures contract in April of 1990 with Henry Hub as the delivery point.
Futures contracts are considered financial in nature. Although they include a commitment for physical delivery of natural gas, the bulk of futures contracts are not held to physical delivery. Instead, futures contracts are bought for price insurance or speculation and are sold as they approach expiration to “claim” the insurance or profit/loss. Natural gas futures contracts are very liquid - hundreds of thousands of natural gas futures contracts are traded every day.
Buying and selling natural gas futures contracts allow market participants to lock in the price of natural gas for delivery in future delivery periods. For example, if a trader purchases a futures contract for January 2020 at $3.10, the January 2020 natural gas price becomes fixed for the trader (up to the volume of the contract). When the January 2020 contract settles in late December 2019, the trader will pay his counterparty $3.10 and receive the market price (more accurately, the trader would sell the futures contract for the current market price and close out his position). Although Futures contracts allow parties to “fix” their price for natural gas, the NYMEX’s futures contract specifically defines the point of delivery for the natural gas as the Henry Hub and so does not address Basis.
Natural Gas Futures -
Buying / Selling the NYMEX LD1