Contracting

Purchasing and moving natural gas from wellhead to burnertip requires contracting for both physical supply and transportation services. Pipeline capacity is sold on either a firm or an interruptible basis. Firm transportation is high priority service that is interrupted only for "force majeure." Interruptible transportation is a lower priority service subject to interruptions on short notice, and therefore can be arranged at a lower cost.

Supply contracts negotiated in the 1970's when natural gas prices were high and supplies scarce were often of long duration; several extended up to 20 years. In the late 1970s, wellhead price regulation provided little incentive to increase gas reserves. A shortage developed which led to prices of approximately $8.59/Mcf (thousand cubic feet), compared with roughly $ 1.40/Mcf today. Pipelines had attempted to lock in long term sources of gas at any price in order to meet their contractual obligations with end-users. Tight supply conditions were instrumental in their negotiations of "take-or-pay" contracts with producers. These contracts required the gas purchaser to pay for a min­imum production from a producer at an agreed upon price, whether or not the purchaser took that quantity. As stated above, some of these contracts were for periods as long twenty years! (Contract tenors have declined substan­tially in the post-regulatory era.)

When gas prices declined in the 1980s due in part to the recession and the impact of lessening regulation, previously negotiated take or pay deals required pipelines to buy gas at prices as much as six times the then prevailing spot price. During this time, fuel oil was cheaper and thus became an economical substitute for gas. As pipelines became hard pressed to meet their take-or-pay liabilities, producers attempted to sell to end-users on a short term basis and the natural gas spot market was born.

Spot natural gas contracts are not "spot" in the strictest sense of the word. They are contracts for delivery and receipt of natural gas within one month. Spot trading accounts for approximately 75% of the natural gas market, according to some estimates.¹ Prices for spot deals are most often fixed to a published price benchmark such as Gas Daily. Occasionally, when gas prices change substantially between contract execution and final delivery, the purchaser will not take the gas from the seller or the seller will not deliver the gas to the purchaser. In these cases, the price of gas may be renegotiated by both parties. This practice, known as retrading, is allowed under certain circumstances. Contracts with retrading provisions essentially have option value attached.

Most contracts for next month delivery are finalized during what is known as bid week. During bid week, shippers nominate, or make capacity arrangements, with pipelines. Because the quantity that a shipper can move is limited by the capacity arrangement, the gas price and quantity are finalized during this same period. Bid week occurs at the end of each month. These contracts have particular economic benefit for firms that have fuel switching capabilities since they can be renegotiated each month to reflect the most cost-effective fuel choice.