For natural gas producers, the prospect of selling molecules at Henry Hub is a goal has all too often led to value destructive decision making. For some, this has come in the form of burdensome transportation contracts, and the subsequent build out of G&A heavy physical marketing teams. For others, this goal is approached through the more efficient, but still incomplete, process of concurrently de-risking both NYMEX and basis exposure. The later solution does, in effect, get the molecules to Henry Hub for a known price, but only insofar as the Index market at which the physical molecules are sold does not incur steep discounts.
The most efficient tool to use when trying to reach Henry Hub is often a Physical or “Phys” Basis trade. Proficient marketers of physical natural gas are well aware of this type of transaction while E&P management teams, tasked with being good stewards of public or private capital, often remain marginally informed or in the dark on how to most efficiently pair financial risk management with the physical sales of their production.
A Phys Basis trade is a transaction between a buyer and seller at a fixed differential to the monthly Henry Hub Index price, or by proxy the expiration of each monthly NYMEX contract. The only remaining floating price component is the NYMEX leg, which importantly faces the most liquid natural gas derivative market in the world. As a result, the producer has achieved its objective of selling at a Henry Hub price without adding any additional risks/costs/or variable transportation liabilities.
It is also important to discuss the limitations of deploying an aggressive Phys Basis marketing strategy. First, is the tenor limitation of this strategy relative to selling forward financial basis contracts. As a rule of thumb Phys Basis transactions are available for up to 24 months, with liquidity increasing for shorter duration deals. The most traded and liquid Phys Basis markets are winter seasons (Nov-Mar), summer seasons (Apr-Oct). or calendar years.
Conversely, financial basis trades in most markets can be efficiently executed up to 36 months, and with minimal impacts for irregular start/end dates. Another limiting factor with the Phys Basis approach is understanding the difficulty of unwinding a Physical Basis trade should the need arise. This issue can be particularly problematic when production comes in below what has already been sold forward physically, and the spread between Henry Hub and the local market has contracted or narrowed.
Bottomline: A Phys Basis strategy can provide a realized price to producers which A) minimizes or eradicates mid-to-bid spread losses accepted in most financial basis transactions, B) is better than the financial basis equivalent when downstream Index market premiums move up relative to the local market, C) completely erases the risk of greater index price discounts and D) optimizes your credit base by executing hedges through physical sales contracts.
While a Phys Basis strategy will never stand entirely on its own as a means to manage a producer’s exposure to local market pricing relative to Henry Hub, it is an ideal complement to a corporate risk mitigation plan. When implemented efficiently it will highlight the critical importance of cohesive, and integrated, financial and physical market knowledge. A siloed approach to financial risk management and physical marketing at best deteriorates option value, and at worst creates timing and knowledge gaps capable of materially impacting returns relative to capital plan. Even the most astute/diligent CFO managing a financial strategy will likely underestimate the impact of Index price volatility, downstream market fluctuations, and execution costs relative to market. At the same time, a seasoned CMO is often limited by counterparty diversity and tenor limitations. Utilizing combined insights of both financial and physical markets is a core tenet in strategy creation and execution phase for Mobius Risk Group.