Basis Changes - A Key Factor in Energy Buying Strategies

February 2010

• Until this past autumn, AECO prices tended to be at a large discount to NYMEX prices. However, that discount has narrowed by approximately half. A similar trend is observable between AECO prices and those at Ontario's Dawn pricing point. This discount has also been narrowing as AECO has become relatively more expensive over time.
• End users in Ontario have been taking advantage of AECO's discount to eastern pricing points such as Dawn by buying the commodity at a floating AECO price and fixing a basis to Ontario. This strategy was prevalent for consumers who were reducing the amount of TransCanada PipeLines capacity they were holding.
• Basis relationships have changed, suggesting the focus of a buyer's strategy should shift to saving money, with less emphasis on merely beating the pipeline toll.

Three ships lie at anchor for loading and unloading in the harbour: the Louisiana Lady, the Alberta Clipper, and the Breaking Dawn.

Of course, all three ships fall and rise with the ebbs and flows of the tide. But there are other changes going on that are maybe not as easy to see. As the amount of cargo on each ship changes, the ship rides higher or lower in the water. Not too long ago, the deck of the Alberta Clipper rode more than 1 m lower than the deck of the Louisiana Lady. However, over the last short while, supplies have been removed from the Alberta Clipper at a faster rate than they have been removed from the Lady, and the Clipper now sits only 0.3 m lower than the Lady.

Since the recent low tide, all three ships have been rising, but observers note the Alberta Clipper has risen faster than the other two ships.

Breaking Dawn has in the past, often been about 0.25 m to 0.45 m above the Louisiana Lady. Today Dawn lies 0.3 m higher, so pretty much where she usually is. On the other hand, until recently Dawn was around 1.3 m higher than the Alberta Clipper, The current difference between those two ships has been reduced to half of what it once was.

To understand the movement of the ships, one has to understand that there are two sets of forces at play. Global forces, like the tides, affect all three ships. But there are also forces that are specific to each ship that affect its movements relative to the other vessels.

Of course, this maritime metaphor describes the circumstances affecting gas prices in North America. In gas market terms, the "basis" is the difference in prices between two market points. Similar to the deck of the Alberta Clipper being 0.3 m below the Louisiana Lady, prices at the AECO/NIT trading point in Alberta are US $0.30/MMBtu below prices at the Henry Hub in Louisiana. The AECO-NYMEX basis is -$0.30. Not so long ago, it was more like -$1.20. Although gas markets have been down and up, it is important to note that Alberta prices have risen more than Gulf Coast prices over the past few months. The traditional discount for Alberta is now smaller. The "basis has narrowed".

At the same time, prices at Dawn in Southern Ontario are about US $0.30/MMBtu above Henry Hub, within their traditional range. So Dawn and Henry Hub have been moving more or less together. It follows then that Alberta prices are at less of a discount to Dawn prices than they used to be. The Dawn-AECO basis has also narrowed. In the past, it has often been in the US $1.50/MMBtu range. More recently, it has been around the $0.65 mark.

Alberta's gas production has been falling in the second half of the past decade. This local trend needs to be understood in conjunction with the overall ebbs and flows in North America's gas supply/demand balance. As a result of the local Alberta trend, one would expect prices of Alberta's natural gas to rise relative to prices in other basins. The graphs below illustrate the trend in basis between forward prices in Alberta (AECO price) and those elsewhere in North America (NYMEX price in Louisiana and Dawn price in Southwestern Ontario).

The graphs show that natural gas in Alberta for forward delivery has become relatively more expensive over the past year. Until this past autumn, AECO prices tended to be at a discount of roughly US $0.70/MMBtu to NYMEX prices. However, that discount has narrowed to approximately US $0.35/MMBtu. The sudden narrowing in October 2009 was caused largely by a prolonged period of below-normal temperatures in Alberta, which increased local demand for natural gas. Hence AECO prices rose. A similar trend is observable between AECO prices and those at Ontario's Dawn pricing point. This discount has also been narrowing as AECO has become relatively more expensive over time.

For end users of natural gas in Ontario and Quebec, the relevance of the Dawn-AECO basis is reflected in how they purchase the commodity. Many end users in Ontario have been taking advantage of AECO's discount to eastern pricing points such as Dawn, by buying the commodity at a floating AECO price and fixing a basis to Ontario. So for example, the buyer would commit to buy in Ontario at AECO index + $1.20/GJ. This strategy was prevalent for consumers who were reducing the amount of TransCanada PipeLines capacity they were holding. If the basis could be locked in for a cost less than the transportation cost on the pipeline system, then the buyer knew that reducing their TransCanada contract was a winning strategy.

This strategy made sense when the basis was close to the pipeline transportation cost, and the basis seldom was less than $1.20/GJ. But those conditions have changed.

Today, the pipeline costs are well above the basis and are likely to stay there for some time. Meanwhile, the basis has moved below $1.20 and could narrow further. This suggests the focus of a buyer's strategy should shift to saving money, with less emphasis on merely beating the pipeline toll.

It is uncertain how long this trend of narrowing bases will continue. Since basis is the price differential between two points, developments at either of those points will affect the basis. A cold start to autumn in Alberta pushed up demand and AECO prices and reduced the discount of AECO to Dawn and NYMEX. Anything that further tightens the supply/demand balance in Alberta would tend to push AECO prices higher. These factors could include higher local demand (e.g., gas use in oil sands' development, extreme temperatures which magnify heating demand) or cancellation of supply projects involving unconventional gas extraction in Alberta. At the same time, factors that increase supply in downstream markets would push prices down in those markets. One example would be the development of unconventional gas supplies in the Marcellus Shale deposit in Appalachia. Taken together, these factors would tend to further narrow the AECO-Dawn basis.

Basis relationships are not fixed. Their movements reflect differences in the changes in the supply/demand balance in different markets. It can pay for end users to be aware of and understand these changes so their energy buying strategies can be adapted as conditions warrant.

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