Bid/Ask Spreads: Why is the Price Higher When We Buy Versus When We Sell?

May 2008

Writing in the April 2008 issue of Report on Business magazine, columnist Doug Steiner asked "Foreign exchange is the most liquid of all markets, so why does the little guy still get hosed?"

He noted that the spread between the buying rate and the selling rate for foreign currency can be as wide as several percentage points when you go to your bank before your vacation. However, the banks themselves, trading billions of dollars in a single transaction, usually see spreads of only 1 or 2 basis points (1 or 2 hundredths of a percent).

The article struck a chord in our office, because of the many parallels between Steiner's foreign exchange observations and what Aegent sees every day in the natural gas market.

Over the last year, Aegent completed over 2,000 gas purchase or sales transactions for clients (Aegent does not trade for its own account). Sometimes, we were buying for one client at the same time as we were selling for another. Other times, we were canvassing 2 or 3 suppliers to find the best price for our client. Over the course of a few thousand transactions, we've learned a bit about margins in the gas market, and how to save money in energy transactions.

The difference between the energy marketer's selling price (their offer) and buying price (their bid) is called the bid/offer spread. The bid/offer spread is both a profit margin and a risk management tool. We're going to look at three key influences on the bid/ask spreads; transaction size, the marketers position, and market liquidity.

Size Matters

Some of the transactional costs in energy marketing don't really depend too much on the volume being traded. If you consider the administrative work in entering a deal into the trader's system, issuing a deal confirmation, tracking the return of that confirmation, and invoicing the transaction, those costs will be the same from one deal to the next, even if one deal is 100 times larger than the other.

For example, if the costs of processing a transaction are $500 per transaction, then a transaction of 250 GJ per day for 30 days will need to generate a margin of at least 6.7 cents per GJ just to cover the transaction costs ($500/7500 GJ = $0.067/GJ). A transaction of 1000 GJ for the same term would only need a margin of 1.7 cents to recover these costs. So marketers tend to provide tighter pricing as the transaction volume rises.

The Marketer's Position

Energy marketers, like banks, expect to make money, so they will always buy low and sell high. However, they cannot always buy low and sell high the same quantity at the same time. Their "book" - their portfolio of buying and selling positions - is likely out of balance at any point in time. They may be a little "long" (the sum of their obligations to buy gas are greater than their obligations to sell). Or they might be "short" (they have obligations to deliver more gas than they presently own). And the energy market is notoriously volatile, with prices moving by the second. If the marketer is temporarily long, and the market is falling, he could lose money if the market falls too much before he can sell his excess gas. Conversely, if he is short and the market rises, the gas he buys to balance his obligations to supply gas could put him in a loss position.

So, the energy marketer who is asked for an offer price has to price the sale with his book position in mind. For a marketer who is long, a sale will reduce his risk, so maybe he'll accept a slightly lower price and lock in a risk free profit. For a marketer who is already short, another sale increases his risk by making his book even more unbalanced, and so he will likely want a higher price before he is prepared to take on that additional obligation.

No one marketer always has the lowest price in the market (although we have found a couple who always seem to be among the highest!). As a buyer, you want to be able to do some price comparison among 2 or 3 sellers each time you are looking to buy. That is the only way to know whether you are getting the best price you can get for that transaction at that point in time.

The impact of Liquidity

Another factor affecting the bid/offer spread is the liquidity of the market. Liquid markets are those where many participants are trading almost continuously. Illiquid markets are those that are more "lumpy". The gas markets at AECO and Dawn are liquid markets, whereas the market at Parkway is less liquid. A marketer selling or buying gas at Parkway is likely to have to hold an unbalanced position a little longer than he would have to do at Dawn. The longer he holds his position, the more likely it is that prices can move against him to a larger degree. So he will need to have a wider bid/offer spread to cover the greater risk of trading at Parkway.

Just as some geographic markets are more liquid than others, some transaction terms are also more liquid than others. The market for gas for next month at Dawn is very liquid. The market for gas at Dawn for a five year term beginning in November is quite a bit less liquid. The less liquid the market, the greater the price differences will be from one marketer to the next, and the more it pays to be able to shop around.

The three factors of transaction size, supplier choice, and liquidity of market all came together in a recent situation involving two Aegent clients. For balancing reasons, one client had a small volume of gas (less than 300 GJ per day) to sell at Parkway for less than a month, while a second client had a similar volume to buy. Canvassing marketers, Aegent found a bid/offer spread of 33 cents per GJ between the lowest price that could be bought and the highest price that could be sold. We informed the two clients of the situation, and helped them structure a transaction directly between them, and they split the difference. The result was that the seller got a price that was 16.5 cents higher than he otherwise could have got, and the buyer paid a price that was 16.5 cents lower than he otherwise could have got. (Aegent provides its services on a fee for service basis, so there was no margin to be paid to Aegent.)

Ideally, buyers can pay less if they can avoid illiquid markets, transact in larger quantities, and have the flexibility to shop around among suppliers to find the best price.

In his article, Doug Steiner noted that the foreign exchange wicket at the airport had a 14 cent bid/offer spread on Canadian/US exchange. (It cost $1.07 Canadian to buy $1 US, but if you sold $1 US, you'd be paid $0.93 Canadian.). He observed that only uninformed or desperate buyers would fall prey to that spread, a lesson that translates well into energy markets.

As an energy buyer, be informed and be prepared to avoid paying big spreads on your energy transactions.