U.S. NATURAL GAS HUBS SYMBOLIZE ORDER 836 MARKETING EVOLUTION

A.D. Koen

Senior Editor-News

Of all U.S. gas industry responses to federal efforts to reorganize interstate gas transportation and trading, none is more intriguing than market hubs.

Put forth in the debate over the Federal Energy Regulatory Commission's Order 636 as a way to increase the reliability and flexibility of U.S. interstate gas supplies, market hubs were hailed as a new, advanced level of gas marketing sophistication.

With Order 636's unbundling of transportation and storage services and fees, advocates maintained, market hubs would become focal points of interstate gas transactions. Eventually, they said, large regional market hubs linked by electronic trading systems displaying near-real time market data would form a nationwide clearinghouse in which any seller across North America would be able to offer supplies to the highest bidders, any buyer could find a smorgasbord of gas supplies and select the source best suited to his needs, and any shipper on equal footing with all other players could obtain the services he needed to efficiently move purchased volumes to end users.

In the months leading up to and following implementation of Order 636, a number of companies--mostly affiliates of interstate pipelines, gas marketers, and local utilities--were formed to offer marketing services through repackaged transportation and storage assets. As a result, market hubs are springing up all over the U.S. and Canada, and some gas has begun moving under market hub agreements.

But widespread acceptance and use of market hubs have not yet occurred. Market hub activity mostly is being relegated to brief, minor roles on the fringes of firm interstate gas markets.

Clearly, market hubs as a concept and in reality are only one aspect of evolving North American gas markets. And even skeptics of current market hub capabilities acknowledge that such hubs eventually could become the key marketing links envisioned by their creators.

ARBITRAGE OPPORTUNITIES

With half interests through its Hub Services Inc. (HSI) unit in new market hubs at Chicago and in Pennsylvania and California, Natural Gas Clearinghouse Inc. (NGC), Houston, has emerged as a leader in hub development.

NGC Executive Vice Pres. Jim Hackett said the company began studying market hubs in search of ways to arbitrage pipeline transportation and storage fees and tariffs and prices of gas under Order 636. By wheeling gas--simultaneously receiving and redelivering gas across hub facilities--NGC believed it would be possible to trim supply costs and the costs of providing services to customers.

"We weren't sure everybody else saw them the way we did," Hackett said. "But we thought FERC would try to support the industry in setting up hubs and prevent pipelines from taking discriminatory actions against them."

NGC reckoned the first company to begin organizing and developing a market hub at a given site would be in the best position to protect that point as a potential transfer-pricing point for paper and physical transactions. It set about searching for the best locations.

Based on its insights as a major gas marketer, NGC began identifying points on the North American gas grid, "natural pooling points" with multiple pipeline interconnects sitting midstream between major gas supply and market areas on underutilized interstate gas transportation systems. NGC determined the location should have a downstream sales capability, as well as good access upstream to supply areas.

At the time, NGC didn't consider the volume of gas flowing across a prospective hub area as a siting criteria. But Hackett said a location handling 500 MMcfd of gas would have more than enough load to be an effective market hub.

REPACKAGING ASSETS

Because developers are focusing on sites with such specific characteristics, most new gas market hubs are being organized around repackaged assets of existing gas systems as opposed to building or expanding facilities.

And even in instances in which new facilities are needed, hub developers in many cases are able to achieve significant improvements with small investments.

NorAm Energy Corp., Houston, for example, is adding four long haul interstate gas pipelines to the seven already connected at its Perryville hub in Northeast Louisiana. The hub was created before issuance of Order 636 through a pooling of assets owned by NorAm's regulated interstate pipeline units, NorAm Gas Transmission and Mississippi River Transmission.

By November 1994, when all four new interstate pipelines will be connected to Perryville, NorAm will have laid less than 10 miles of pipe for the project.

Steve Randall is manager of Perryville hub operator NorAm Hub Services Inc. (NorHub), created last April.

NorHub buys services from companies with systems connected to Perryville, surveys the needs of shippers using the hub, and rebundles those services into customized packages. In that role, NorHub acts not as a marketer but as a facilitator creating a way to use the hub.

Randall said, "With control of assets shifting to shippers from pipelines, we felt we needed to put together services that provide mechanisms that allow our customers flexibility in the market to be able to react to changing market conditions. For years, there has been 400-600 MMcfd of gas bought and sold at Perryville. We're hoping to increase that to 2 bcfd."

In addition to NorHub, other main customers using Perryville include companies arranging transportation for supplies aggregated upstream of the hub and producers who have no way out of the Midcontinent region other than a NorAm subsidiary interstate pipeline.

PAPER VS. PHYSICAL SERVICES

Walter E. DeForest, president of the Leidy Hub Inc. (LHI) unit of National Fuel Gas Co. (NFG), said a hub can be established anywhere marketing services are needed and there is adequate infrastructure to perform the needed functions.

LHI and NGC's HSI are 50-50 partners in Ellisburg-Leidy Hub Northeast Inc. in Northeast Pennsylvania.

Before FERC's issuance of Order 636, the Ellisburg-Leidy area was a gas industry crossroad with Canadian gas flowing to customers in the U.S. Northeast by way of systems owned by another NFG unit, National Fuel Gas Supply Corp. (NFGS). Under Order 636, NFGS facilities provide the physical services created and sold administratively by Ellisburg-Leidy Hub Northeast.

Physical hub services offered by NFGS include parking, wheeling, and gas loans to resolve imbalances under FERC tariffs. Ellisburg-Leidy hub offers the same services administratively, as well as title transfers.

DeForest said moving gas administratively through the Ellisburg-Leidy hub might or might not result in a physical flow of gas across NFGS facilities.

"So more gas is moving across Ellisburg-Leidy hub on paper than is moving physically across hub facilities," he said. "Volumes of gas moving administratively across a hub would provide a better description of what that hub is doing than physical flows."

AVOIDING CONFLICTS OF INTEREST

At Henry hub, in operation in South Louisiana since March 1988, operator Sabine Hub Services Co. (SHS), a unit of Texaco Inc., tracks physical and administrative gas volumes flowing across hub facilities. But when it comes to services, SHS takes extra care to assure customers it is not in competition with them.

Hub owner Sabine Pipe Line Co. provides wheeling at the hub for a flat volumetric fee, regardless of the path of physical flow or line pressures involved, and since 1991 has offered title transfers. Both services are available through SHS.

SHS Pres. Jagit S. Yadav said other services available at Henry hub are provided by companies making market at and around the hub.

Yadav said hub officials made it clear from the beginning that it would concentrate on providing services and not engage in activities that would put it in conflict with its customers.

"We consider ourselves to be in a role of fiduciary responsibility," he said. "For a hub to succeed in that role, the hub operator has to work in such a way that everybody can trust what's going on and just take advantage of the services that are available."

NGC's Hackett is keenly sensitive to concerns about the confidentiality of market hub information. But he said clients at Chicago hub, which HSI operates on the system of Northern Illinois Gas (Nigas), Aurora, Ill., can be sure of the sanctity of information at that location.

Hackett said the agreement under which HSI operates the Chicago hub is more stringent than required by federal regulations in Order 497, "which the industry tested and found to be a workable relationship between transporters and affiliates."

NGC has taken pains to separate HSI offices and employees from NGC to assure that no data are exchanged except as allowed by the agreement.

"In addition to that, contractual remedies for violations of the hub agreement are drastic," he said. "Unlike FERC, which can fine a shipper for violating federal rules or reverse a transaction under Order 497, Nigas can kick us out if it finds we are discriminating."

Hackett said he expects Nigas would ruthlessly investigate allegations of discrimination or preferential treatment because, "in the end, it's in Nigas's strong interest to be sure the hub works." Because the Chicago hub has been in operation for more than a year and because HSI is not the only company capable of operating the hub, it wouldn't pose much risk for Nigas to find another operator.

IF THEORY HOLDS

If North America's gas industry conforms to economic theory, proponents expect market hubs to reduce barriers to efficiency by trimming transaction costs, making gas industry price information more readily available, and reducing institutional constraints such as receipt and delivery points.

More efficient movement of physical gas is expected to reduce volumetric costs of transportation and storage. At the same time, transparent data about prices and market activity should help sellers get the best price possible for their supplies and enable buyers to find the most affordable supplies.

With those factors present, theory holds, all hub users should benefit from the simplicity and ease of hub transactions, a factor that likely would further reduce transaction costs. Yet at this early stage of development, few of the many players that hub developers say should have something to gain have become hub customers.

Vernon T. Jones Jr., senior manager of the energy consulting practice in the Houston office of Coopers & Lybrand LLP, has been tracking and compiling market hub information since spring 1993.

In its first survey about 1-1/2 years ago, Coopers & Lybrand counted about 15 existing and planned gas marketing hubs. In its most recent update, completed last week, the company counted 40 hubs, including about a half dozen projects announced since last May.

Based on the idea that the widest possible participation in gas markets is good for the gas industry, Jones is convinced that widespread use is essential to the success of market hubs as well. However, for the most part, Jones said, small gas producers and end users haven't started using market hubs because they generally don't hold firm transportation capacity or ship large volumes of gas around hub facilities.

Conversely, Jones surmises that most market hub customers so far are companies holding large amounts of firm capacity and with extensive trading and/or transportation operations in market areas. Those customers are attracted more to hubs' physical capabilities than administrative or financial services.

SUPPLY AREA EXPERTISE

Scott R. Smith, vice-president of Vestar Gas, Dallas, a unit of Vastar Resources Inc., Houston, said his company evaluates weekly and monthly whether to use certain hub services. But the company hasn't had many opportunities to use the services because of its role as a large gas producer/aggregator.

In the new business environment created by Order 636, Vastar has focused on obtaining term markets with local distribution companies (LDCs) and has structured its portfolio of supply commitments around primary delivery points in producing areas. Because the company typically isn't moving large volumes of gas to market areas, Smith said, it doesn't make sense for Vastar to be a big market hub user.

"There are a lot of different ways to achieve flexibility, and services that can provide flexibility might be cheaper at other locations than comparable services a hub is offering," Smith said. "We can provide a lot of different services ourselves, whether it's flexibility, parking, or whatever, by carefully managing our supply and contracts. Or we can buy services from other companies that are not necessarily hub operators."

Smith said for Vastar and other companies focusing on developing supply area expertise, venturing into a market area is difficult because they are forced to operate on unfamiliar turf.

"In the production area, we have the transportation and aggregation expertise to move gas around to meet our commitments," he said.

DUPLICATING SERVICES

SHS's Yadav said in some other instances a producer or aggregator might be interested only in taking a gas supply to market and not in switching back and forth to find optimal markets. In some situations, buyers behave similarly.

In addition, Yadav agrees that some of the services needed at such times often can be obtained away from hubs at other locations in the transportation chain. But in situations in which a buyer or seller is trying to optimize his trading position, market hubs can play a key role.

Bob Purgason, director of information services and gas projects at Williams Energy Ventures Inc. (WEV), Tulsa, said most producer/aggregators prefer to deliver physical gas at their primary firm delivery points regardless of where the buyer wants to take the gas.

Purgason said an individual supplier can come close to providing the same flexibility and reliability as a market hub if his aggregation system has storage or is supplied by several gathering systems.

"But he can't easily duplicate the hub's proximity and smaller changes that have to be made on the nomination side of transportation," he said. "And obviously, with a number of different supply and delivery points being involved, a deal offering hub-like services is going to be more complicated."

If a buyer-seller clash over a delivery point stands in the way of working out a deal, a market hub is a good compromise site for a trade to take place.

"A hub can bring the possibility of multiple delivery points to a supply portfolio that can't be replicated at separate delivery points," Purgason said.

REALIGNING DELIVERY POINTS

Purgason agreed that market hubs are operating mostly on the fringes of mainstream gas industry activity because many shippers under Order 636 set up firm delivery points at other sites on the U.S. interstate gas pipeline network. But he warned against casting hubs prospectively as fringe gas market players.

"Shippers have the flexibility under Order 636 to realign firm delivery points," Purgason said. "My view is, as people gain experience with hubs and start using hubs more for transacting business, shippers will tend to move delivery points or trading points to more successful hubs.

"At that point, successful hubs no longer would be on the fringe of the firm transactions. They would become primary feeder points in more firm agreements."

Other Williams Cos. Inc. units are involved heavily in North American gas markets. But WEV isn't developing and doesn't operate market hubs. Rather, in partnership with Westcoast Energy Inc., Vancouver, WEV is introducing Streamline electronic trading system to hubs across North America.

Traders began using Streamline in February at the Alberta hub in Calgary and in June at Canada's Empress hub and at Carthage and Waha hubs in Texas. Streamline based gas trades are set to begin in third quarter at the Lebanon hub in Ohio and the Rocky Mountain market center at Opal, Wyo.

Purgason said pipeline tariffs under Order 636 have enough flexibility that as hubs prove their utility, instead of using a firm delivery point at the tailend of a single gathering system, a seller can use a hub served by multiple gathering systems and intrastate and interstate pipelines.

"Multiple supply sources for a firm delivery point give a shipper or buyer the reliability he needs, as well as flexibility to react as the market changes," he said.

ELECTRONIC TRADING

Coopers & Lybrand's Jones said wider use of electronic cash trading systems like Streamline and the Channel 4 electronic trading system being developed by the New York Mercantile Exchange and Enersoft Corp., Houston, are a key to wider hub use.

"That lets anybody play," he said. "For the price of a few hundred dollars a month a company can put a terminal in key employees' offices and accomplish gas market transactions nearly with the stroke of a key."

Because market hubs and services are still being defined, each hub operator has a little different version of the way he wants to operate to take advantage of his unique asset package.

"From there, they're talking with their normal customer bases and providing additional tweaks the customers want," Purgason said. "It's a very interactive process."

He said installing an electronic trading network among North American gas market hubs likely will ease hub use and simplify gas market transactions by helping standardize activity at different hubs.

When WEV and Westcoast Energy introduce Streamline to a market hub, they adapt the services provided at that site to fit within a structured subset of hub procedures that allow electronic trading to take place. With an electronic market hub trading network, traders can track gas price differentials among all the hubs and buy gas daily in the same transaction intensive manner at any hub linked to the net.

As North American gas markets evolve, different hubs likely will continue offering a variety of services as each hub administrator seeks to optimize the efficiency of his hub's facilities.

"But there will be a layer of standardization the industry can enjoy," Purgason said. "Both elements are important."

LOOKING TO THE FUTURE

Gas industry players might disagree about the extent to which gas market hubs today are providing--or not providing--services in North America's gas markets. But agreement is widespread in the industry that hubs appear destined to transform gas trading and transportation.

Hackett said tying large regional hubs together with a unified electronic trading network is the next logical step in developing market hub capabilities. He said a master hub electronic trading system could be a reality within the next 1-2 years.

"By connecting all the points and providing new services, can we create something bigger and better than what we have today?" he asked rhetorically. "We think so."

While the cost is great of developing the necessary trading capability and providing electronic data interchange to various hubs, Hackett and many others are convinced that including all large regional hubs on the network will lower gas costs volumetrically.

"More important, it could provide arbitrage opportunities on a national basis so shippers could wheel gas to various parts of the country," Hackett said. "And if we could include main hubs in Canada and the border crossing points between the U.S. and Mexico, maybe we could start creating our vision of what an international electronic hub trading system ought to provide in terms of information and services."

Purgason said many gas industry elements in the future will determine the relative success of hubs. Price transparency is important to hub success because reliable price signals could greatly simplify the way gas is bought and sold.

But perhaps the most important factor is the extent to which hub services and technology can provide certainty and comfort to hub customers. As North American gas markets continue to evolve, each player will tend to settle into roles or activities he is certain he can provide profitably, reliably, and at a fair price.

"With downsizing pressures everywhere and all the computing and communications changes going on, the time is ripe for people to be reshuffling all those decks," Purgason said. "In this business environment, market hubs could become the meeting place for physical reliability and transactional efficiency on North American gas markets.

"Having that focal point makes accounting easier and brings added value to the physical volumes. I just don't see how--prospectively--hubs can't play a major role in the marketplace."

Given the constant change throughout North American gas markets, Vastar's Smith said the potential exists for issues to arise that could force supply area specialists like Vastar to rethink their strategies. For example, Smith sees signs that markets could open enough to enable upstream suppliers to begin marketing gas downstream to small commercial and industrial accounts.

"Right now, we can be really good at maintaining our cost position in the supply area," he said. "But as the markets change, circumstances could force a company to consider whether to expand marketing operations downstream into the market area or to retreat further into the supply area.

"If that question were Put to us today, it would be a tough decision. There is just too much uncertainty."