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  • Print publication year: 2020
  • Online publication date: October 2020

2 - Long-Term Contracts: Their Role and Impact on Natural Gas Pricing

Summary

This chapter will focus on the impact of LTCs on competitive, nonregulated prices, that is, free-range spot and exchange– traded prices. It will explore how LTCs modify actual pricing patterns in competitive, nonregulated NG markets, as distinct from hypothetical pricing models that ignore the existence of LTCs and hypothesize market pricing as if LTCs did not exist. These are critical questions related to our exploration of how to properly structure NG pricing so that NG fulfills its historic role as a transition energy source.

Historically, LTCs have been a risk mitigation instrument that provides security of supply for buyers and security of demand for sellers. Dramatic changes in global NG markets have led to questions about the role of LTCs in the future of the NG industry. Will they maintain their importance, or will short-term contracts and spot deals take their place? If LTCs do remain and continue their dominant position in the NG market, what will they look like in the future? What is the optimal combination between the LTCs and spot trades?

Assessing the impact of LTCs on NG pricing is extremely important for a proper understanding of NG price behavior and for forecasting it. As will be illustrated in this chapter, it is important to understand the study of price anchors or centers of gravity as an aspect of general commodity price forecasting. Price anchors or centers of gravity are the price points to which prices eventually return once the cause of any deviation from the midpoint that is caused by a market imbalance goes away. In the world of commodities, this mid-to long-term center of gravity is an equilibrium price representing the full-cycle costs of production, delivery of the product to the customer and a reasonable profit margin.

Having stated this general principle, prices in those industries where LTCs are the dominant form of seller and buyer interaction do not follow the general rules of commodity pricing. My analysis shows that in these circumstances, the price contained in the LTCs acts as a substitute for the anchor price or center of gravity that occurs with other commodities. In NG markets dominated by LTCs, spot prices have a specific relationship to the price level set by LTCs and hover around this price level.