Liquidity and Its Practical Importance to Energy Buyers

September 2010

• In the energy market, liquidity speaks to how quickly and easily you can buy or sell a volume of energy at a delivery point and for the term of interest.
• In natural gas, there are certain points in the continental pipeline grid that have come to be known as market hubs. Many pipelines come together at or near one point. Sellers from many different areas are able to deliver their gas to that point and buyers from many different locations can buy gas at that point and take it to where they need it. The presence of many buyers and sellers adds to liquidity.
• For energy buyers, it pays to purchase in liquid markets. It will be easier to buy promptly in the quantities needed, and prices will be more competitive from one supplier to the next.

In financial markets, the term 'liquidity' refers to the ease with which an asset can be converted into cash, without a discount in price. So, for example, if you held 1,000 shares of an actively traded stock in a public company, you could quickly and easily convert the full market value of the stock to cash, on most days. However, if you owned a piece of antique furniture of the same notional value, it would be much harder to quickly realize its full value in cash.

In the energy market, liquidity speaks to how quickly and easily you can buy or sell a volume of energy at the delivery point and for the term of interest.

In natural gas, there are certain points in the continental pipeline grid that have come to be known as market hubs. Often, many pipelines come together at or near one point, and this helps to promote liquidity. Sellers from many different areas are able to deliver their gas to that point and buyers from many different locations can buy gas at that point and take it to where they need it. The presence of many buyers and sellers adds to liquidity...there is bound to be someone who is interested in meeting your need to buy or sell gas.

The number of trades that take place daily at a point is often a good indicator of liquidity. So too is the bid/offer spread. This is the difference between the price someone will bid to buy gas from you and the price at which they will offer to sell gas to you. Anyone who has converted currency for a trip abroad is familiar with the concept that the bank's buy price and sell price are different. If you are buying or selling US dollars at a bank in Canada, the spread is narrower reflecting a liquid market. If you are buying Swedish kroner, the spread would likely be wider.

In part, this reflects the risk the bank is taking. The value of US dollars is constantly changing (in Canadian dollar terms), and if US dollars are falling in value, the bank doesn't want to be caught holding excess US dollars. However, if the bank buys US dollars from you, they could quickly be selling them to another customer, so they won't be forced to hold them for too long.

However, they don't sell a lot of kroner, so they will be holding that currency for longer. They need to buy from you at a price that is well below their selling price, to leave room in case the market value (hence the selling price) falls before they are able to unload those kroner. So the spread is wider.

Another characteristic of liquid markets is that there is good price discovery. Because there are many parties actively trading, they all know what the current price is, and they all have a very similar price. In a liquid market, parties would immediately shift to anyone who had a better price, so arbitrage brings all the prices in line. In a less liquid market, the price available from two different parties can be quite different. If only a handful of banks will sell you kroner, it may not be easy for you to find out who they are and compare their prices.

Of interest to gas buyers in Ontario, key purchase points like Dawn, AECO, or the Henry Hub are very liquid trading points. Other key purchase points like Empress, Parkway or the Enbridge CDA are less so.

On the ICE trading platform, the October Henry Hub contract was recently trading with a spread of only 0.4 cents between the bid and the offer. The AECO/NIT instrument for October had a 2.5 cent spread at the same point in time. AECO/NIT is largely of interest to Alberta producers and traders, while Henry Hub attracts buyers and sellers from across North America and is therefore more liquid.

In one recent transaction for gas to be delivered in eastern Ontario, there was a price difference of 14 cents from the low priced supplier to the next best price, and a price difference of 18 cents between suppler #2 and supplier #3. This reflects the illiquidity of trading at this delivery point.

Liquidity also comes into play with respect to the term of purchases. Trading for gas to be delivered tomorrow or next month is much more active (liquid) than trading for gas to be delivered in 2013.

What does all this mean for practical buying strategies?

Well, it pays to buy in liquid markets. So, for example, a power generation buyer who is likely to be engaging in many transactions to buy gas at Parkway may prefer to buy gas at Dawn and have pipeline transportation to get the gas to Parkway. They have shifted their gas buying to a more liquid point. It will be easier to buy promptly in the quantities needed, and prices will be more competitive from one supplier to the next.

If there is no effective option for shifting purchases to a more liquid market, then the buyer must make sure to shop around and compare prices. There may well be very significant price differences from one supplier to the next in such a market...it may not be easy to find the best price, but it is often worth the work.

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