Basis Risk

The definition of commodity which we often use to signify like, interchangeable products cannot be applied as freely to energy products as it is to other commodities, such as gold. That is, unlike an ounce of gold, a barrel of crude oil in London may not be the same thing as a barrel of crude oil in Chicago. Variances of grade, sulfur con­tent, delivery and storage costs — among other things — give rise to numerous basis issues which must be carefully managed.

Price risk can be reduced by hedging with either exchange traded or OTC contracts. However, if contract terms are not equivalent, substantial basis risk can result. In the natural gas market, basis risk incorporates the difference between the natural gas price at two different geographic points. In the crude oil market, basis risk incorporates grade differences as well as location differences. Liquidity, pipeline expansions and shutdowns, gas reserve develop­ment, strikes at production facilities, weather, and the pricing relationship of substitute fuels all impact basis risk.

Local events are as important to basis movements as global events are to absolute price changes. While the price of oil may be stable on the world market, a pipeline disruption or an excessively cold winter in a local market will cause the basis between that market and the broad market to widen substantially. Consequently, hedging an out of loca­tion cash position may significantly increase basis risk. The NYMEX crude oil futures contract settles to the pipeline price in Cushing, Oklahoma. Because factors affecting local markets can be widely disparate, a cash price for oil located away from Cushing may not move in tandem with the NYMEX contract, leaving the position exposed to basis risk.

Changes in the basis can occur quickly. The NYMEX natural gas contract settles to the Henry Hub price. From February 1993 through January 1994, the differential between the Chicago City Gate natural gas price and the NYMEX Natural Gas Futures contract varied from $0.36 over to $0.12 under. During first quarter of 1994, how­ever, increased demand due in part to harsh weather conditions, pushed up Chicago City Gate natural gas prices substantially relative to NYMEX. On February 7, 1994, the Chicago and NYMEX prices were $2.75 and $2.35, respectively. Two days later, the Chicago price rose to $4.25 while bearish sentiment on the futures market kept the NYMEX price constant. The basis climbed to $1.89. Although the basis fell back to lower levels in the subsequent period, Chicago cash market participants hedging with NYMEX futures contracts were exposed to substantial price risk.

The lack of price transparency may increase basis risk for hedged natural gas or oil positions. Many natural gas contracts are priced off a published reference index. Commonly referenced price indices include Inside FERC, Gas Market Report, Gas Daily, Natural Gas Week, and Natural Gas Intelligence. The published prices are determined by surveying industry participants throughout the marketing chain and do not represent actual transaction prices. Because of a lack of price transparency, the potential exists to alter survey prices for economic gain. Prices corre­sponding to illiquid markets can be particularly vulnerable to manipulation as they are derived from a very limited number of survey participants. Inaccurate price information may cause published index prices to respond differently to market conditions as compared to true transactions prices. This may introduce additional basis risk for contracts priced off published indices.