Volatility of natural gas prices: betting on the climate

As Premier Christy Clark heads off on another tour of Asia this week (from November 21st to December 3rd) to promote British Columbia’s natural gas reserves, let us look at speculators and hedge funds.

In the middle of December 2000, a bill was passed in the United States called the Commodity Futures Modernization Act (CFMA). This bill, also known as the ‘Enron Loophole’ allowed for energy trading to go unregulated.  A lot of people saw this as a favour to Enron, considering that the Texas senator who drafted this bill was married to one of Enron’s directors.

The result of this single piece of legislation is that energy prices were now under the control of speculators.

The price of natural gas which had been trading between $2 and $3 per MMBtu (one million British Thermal Units) suddenly increased to $9 shortly after the Commodity Futures Modernization Act was passed.

The gap between the average spot price and the average of all futures prices increased from 2.1 percent in the 1990s to almost 38 percent in the 2000-6 period.  A standard measure of volatility showed that it increased 475 percent from May 2000 to September 2006.

Industries affected by these volatile price swings were encouraged to hire the services of hedgers – someone who tries to protect against future price changes that could hurt a business; either a user or producer of natural gas. These hedgers invest in gas contracts and monitor how market prices move, trying to make sure they don’t experience sudden, unexpected cost increases. This involves buying or selling futures with the hope that they can offset losses when they go to take delivery of the natural gas. On the opposite side of the scale are the hedge funds used by speculators who bet on the price swings of natural gas; trading rapidly and continuously.

Enron was on the forefront of energy trading and its natural gas traders were gambling (making and losing) half a billion dollars a day.  Soon Enron was joined by pipeline companies, including TransCanada.  Although Enron was supposed to be a pipeline company, it made most of its profits from financial trading.

Enron’s aggressive tactics meant that while the rest of the firm went neglected, its trading volume increased, especially after 2001 when almost 40 percent of natural gas trading was done online.

After the collapse of Enron, there was an influx of new players attracted to this newly deregulated field.  Banks and hedge funds rushed into energy trading.  In just three years, the number of energy hedge funds went from 100 to 500. By mid-2004 speculators made up almost 50 percent of all traders.

The problem with speculators, argued some, is that they bet with other speculators without any regard for the natural gas industry itself. It just ends up being treated like a gambling casino.

Deregulation of Natural Gas:
Starting in the 1930s, the price of natural gas was largely controlled by the government in both the United States and Canada. Customers bought from the pipelines that transported and stored their gas, not producers.

Years of aggressive lobbying broke down any government interference. In 1985, Canada lifted the regulation of the wellhead price of gas. Producers, users, and pipeline companies were free to arrange and negotiate prices on the sale and transport of gas.

TransCanada saw an opportunity for itself. As one of the largest natural gas pipeline systems in North America, connecting eastern Canadian cities with gas from the west, it decided to become the biggest marketer of Canadian natural gas.

TransCanada bought a firm that ran a trading floor as a way of limiting the risks of long-term contracts and also, bring in some money too.  Some of their traders bought or sold a complex deriative known as a swaption; essentially a bet between two traders on the price of gas.

Deregulation transformed the gas business:
Natural gas prices moved rapidly, often dramatically. One day the options traders would be up a million, the next down two. In a good year, its trading operation earned TransCanada $50 million – but for that it needed to buy and sell $10 billion worth of natural gas.  TransCanada decided to shut down its trading in 2001 because the volatility of the trades was affecting earnings, just before the collapse of Enron.

Another company, Amaranth, started an office in Calgary in 2005 and began speculating on the price of natural gas, making heaps of money by betting on that season’s hurricanes.  Increasingly warmer winter temperatures meant that more natural gas was kept in storage.  Amaranth’s traders started placing their bets that the cold weather would return and supply would be tight. This company dealt in tens of thousands of contracts. One contract represented 10,000 MMBtus, so ten thousand contracts would be worth $800 million. In fact, it wasn’t long before Amaranth was trading billions of dollars’ worth of gas.

When Amaranth collapsed in 2007, there was a simultaneous drop in prices. In the States, senators called for a subcommittee to look into the effect of speculation on the energy market and used Amaranth as a case study.

In the report that was released, it was concluded that Amaranth’s excessive speculation “altered natural gas prices, caused wild price swings, and socked consumers with high prices.”  There were several investors who lost millions of dollars including a pension fund (almost $100 million) and Municipal Gas Authority of Georgia ($18 million) which had bought contracts for winter gas in mid-2006 when prices were very high.

Some of the traders bought and sold large volumes of contracts just before they were set to expire, resulting in huge price fluctuations.  Some court cases have emerged which show this activity was actually a calculated attempt to manipulate prices down.

Many hedgers were driven out of business because of excessive volatility. Imagine at first  trading based on supply and demand. Then, all of a sudden, large flows of money come in from where?  Who is going to lose?

Betting on the Climate:
If there is news of an impending hurricane or tornado, speculators will hedge on how far the price will go up as a result.  Said one trader:

“If we had a major hurricane…you’re sitting there saying, ‘Gee, gas could go to $18.’ So the end user is saying, ‘I’ve got to buy gas at $13.’ And then two weeks later it’s valued at $7… it makes it very, very, very difficult for that end user to manage his energy costs.”

What’s the effect on BC?
According to the provincial government, natural gas is supposed to be the economic boon that will pull BC out of debt.  We can learn from our American neighbours that excessive speculation causes excessive volatility which in turn requires more hedging.