Peter Weigand, chairman and CEO of Skipping Stone Inc., explains why basis and capacity trading may finally be ready for prime time.

Seven years ago, when the Federal Energy Regulatory Commission opened the pipeline markets under Order 636, the natural gas trading community salivated over the possibilities of basis and capacity-trading opportunities. The hard-fought victory of deregulation, combined with the potential to create new markets in basis and capacity trading, helped spawn a frenzy of expansion among trading and marketing companies. Finally, natural gas pricing could be risk-managed to a specific location using a combination of basis financial instruments and physical capacity release purchases.

For a variety of reasons, the initial promise of liquidity and prosperity eluded the basis and capacity marketplace. The new owners of firm pipeline capacity tended to be regulated utilities with no compelling reason or reward for releasing their capacity into the free market. Utilities with long-term deals with the pipelines for capacity at maximum rates, combined with free-market valuations that are often at steep discounts to those rates, further inhibited liquidity in the release market.

On the trading side of the equation, the analysis of capacity values were based on inadequate data spread across multiple pipeline bulletin board systems, and were made even more difficult to determine because of the lack of statistically valid transaction volumes. Needless to say, the initial frenzy over capacity and basis markets chilled considerably in those first few years of deregulation. But that has all changed in the past few months.

While the gas market has enjoyed an active basis marketplace and while capacity-release transactions are taking place, recent and probable future events dictate that these markets are poised to boom. Electronic vehicles such as Altrade have been the primary driver behind the recent growth in basis trading. In the capacity-trading marketplace, the newly launched CapacityCenter.com provides an avenue for traders to shop all of the pipelines from one location. The site uses the database platform of the National Registry of Capacity Rights, founded by Greg Lander. According to Lander, “The non-prearranged release market has grown into a billion-plus dollar annual marketplace. With the advent of the long-term deals coming to an end and the opening of more retail gas markets, the availability of non-prearranged biddable deals for the capacity release marketplace is growing dramatically.”

Each of these new players has a different viewpoint on the use of basis and capacity in managing its risk portfolio.

Now that technology and the marketplace are catching up to the liquidity demands of the basis and capacity trading community, the ability to measure and analyze what should be a strong relationship between the two can’t be far behind. With historical transaction data available from Altrade and CapacityCenter.com at a number of physical points and across a statistically significant time frame, the technology tools that analysts require are finally here. Before these systems were available, analysis was confined to those entities that could afford to maintain the required information and the skilled people to work with it. This lack of analysis capability had been a barrier to entry for a growing number of companies that needed to become basis and capacity market players. The analytical barrier is now quickly becoming less pronounced as technology tools continue to become more widely available.

These new natural gas basis and capacity market entrants are coming from a variety of energy niches. Among the more recent entrants are power merchant plant owners and developers, power trading companies, electric utility generators, retail gas aggregators and energy management services companies. Each of these new players has an underlying, and often different, viewpoint on the use of basis and capacity in managing its risk portfolio.

While the trading shop may be interested in capitalizing on arbitrage opportunities between locations and between capacity and its underlying basis valuation, the retail aggregator is undoubtedly more interested in laying off the risk associated with the differential between capacity and basis. For the power generation community, the relationship between natural gas and electricity pricing is especially critical for those swing units using gas as a feedstock. The ability to hedge physical power obligations using basis and capacity instruments may be one of the keys to avoiding the risk of extreme price volatility. While this is good news and creates a healthy growing environment for the basis and capacity marketplace, the major impact for these markets is still just around the corner.

The time is fast approaching when those long-term pipeline capacity deals that were struck during the 636 process will be coming up for renegotiation. It is safe to assume that a healthy portion of contract capacity will become more readily available than it was earlier. Regardless of how those negotiations turn out between the pipelines and the LDCs, everyone can rest assured that it will create an even bigger boom in basis and capacity trading.

Skipping Stone is a diversified energy consulting company. Peter Weigand can be reached at 610-526-2010 or pweigand@skippingstone.com.

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