An Assessment of Prices of Natural Gas Futures Contracts As A Predictor of Realized Spot Prices
October 28, 2005
This article compares realized Henry Hub spot market prices for natural gas during the three most recent winters with futures prices as they evolve from April through the following February, when trading for the March contract ends. Questions or comments should be directed to Lejla Alic at lejla.alic@eia.doe.gov or (202) 586-0858.
Introduction
A futures contract is a binding, legal agreement between a buyer and a seller for delivery of a particular quantity of a commodity at a specified time, place, and price. These contracts are traded on regulated exchanges and are settled daily based on their current value in the marketplace.
Most natural gas futures contracts traded on the New York Mercantile Exchange (NYMEX) end without actual physical delivery of the commodity. Futures contracts most often are liquidated or cancelled out by purchasing a covering position prior to the delivery date and are generally used as a financial risk management and investment tool rather than for supply purposes. Futures contracts are most widely used for hedging. Hedging allows someone to offset the risk of fluctuating prices when he buys or sells physical supplies of a commodity. However, as an indication of market expectations concerning prices in the future, some industry and market participants tend to use the prices for futures contracts as predictions of commodity prices that will be realized in subsequent months, although NYMEX itself does not explicitly encourage this view.
An examination of price data for recent years shows that futures prices are relatively poor predictors of the Henry Hub spot price that is realized during the corresponding delivery or target month, and even the final futures price for a given contract often does not anticipate correctly the realized average spot price. Futures prices vary substantially over time and apparently reflect current market conditions as well as future expectations. The purpose of this analysis is to review the recent performance of futures contracts prices as predictors of the realized spot price. It does not examine the merits of futures trading for hedging or of particular hedging strategies.
The following analysis examines futures contract prices for heating season months (November through March) during three consecutive years (2002-03, 2003-04, and 2004-05) and compares them with average monthly spot prices at the Henry Hub (see Box for a description of the data used in this analysis). The period of analysis for each heating season is the 12 months from April (the start of the refill season) through March (the end of the heating season). Comparing monthly futures and spot market prices allows an examination of the influence of current market conditions on price expectations and provides a basis to assess the performance of futures prices as a predictor of spot prices.