The Law of One Price
AECO / NGX Near Month Index A Primer
By Mike Busby
Would you pay $7.00 for a roll of aluminum foil when one priced two cents cheaper is available at the same location. Foil is foil right? But it's only a couple of pennies. Well, suppose you were buying 300,000 rolls of foil a month. All of a sudden it's a career. Of course what I am getting at here is the economic principle of the law of one price the ability to buy foil at $6.98 and sell at $7.00 will put upward pressure on the cheaper foil and downward pressure on the more expensive foil bringing the price into equilibrium. Presto, through the magic of free market economics we have one price for aluminum foil, probably around $6.99. Everyone is happy and no general economic principles have been violated.
As natural gas market participants are aware, the same concepts apply to commodity markets. In this article I will use this fundamental concept to explore the near month AECO/NIT gas index, officially known as the Canadian Gas Price Reporter's (CGPR) published NGX - AECO C and N.I.T. One-Month Spot Price Index. What it is, why it is used, some of its unique characteristics, and how to estimate its forward value are topics that will be addressed.
Natural gas molecules at the same physical location should be valued at the same price, assuming there are numerous buyers and sellers at that location. The Intra-Alberta Market Centre is one such location, with natural gas being bought and sold by many astute shoppers, every one of them looking for the cheapest molecule. But wait! At Alberta, and many other gas hubs, I can buy gas at a fixed price, a monthly index price, a daily index price, a futures contract plus basis, and so on.
To the un-trained eye the price of natural gas seems to violate the fundamental economic principle of one price. However, battle hardened veterans of any market will tell you that all of these prices, no matter how they are configured, must be the same. If one price is systematically higher or lower than another price, there is an opportunity for arbitrage and the prices will be brought back into equilibrium, just as in the foil example above. This implies that the price of gas for the prompt month has to be equal whether or not you have purchased the gas paying fixed price, CGPR plus a premium, AECO Daily 5a, or NYMEX plus AECO basis.
To illustrate this point I will look at the Intra-Alberta Market Centre and deals priced using the CGPR's published NGX - AECO C and N.I.T. One-Month Spot Price Index. This is a popular index, pricing 56.3 Million GJ's of gas in April alone. The reason for the popularity of gas priced using this index has to do with the way it is calculated. The index is the weighted average of all fixed price transactions for natural gas, transacted through the NGX electronic exchange, and delivered to the Intra-Alberta market during the month prior to delivery.
Students of finance will recognize any instrument priced at this index fall into a category of products once described by Warren Buffet as financial weapons of mass destruction. That's right folks, these instruments are derivatives. They are derivatives because they derive their value from the average of an underlying asset the weighted average price of gas deals at the Intra-Alberta market. However, far from being a financial doomsday machine, the index hopes to achieve one thing the smoothing out of highly volatile price swings that accompany gas prices as contracts approach delivery. In other words, the goal is to reduce the volatility of pricing gas contracts through the use of averaging.
Indexes that use averaging are quite popular. For example, NYMEX L3D (average of the Futures contract over the last three trading days before settlement), and bid-week indexes (indexes that are the average of trades done during bid-week), all use averaging to help smooth out volatility and assure market participants are getting a fair sample of the trading activity on the underlying price of the index. The popularity of these indexes is testament to the fact that market participants need an alternative to buying/selling today only to see the price fall/rise as delivery approached. The solution, give me the average price of deals over the last x number of days so I don't have to worry about buying too high or selling too low.
The difference with the CGPR index is that the averaging period is over the whole month prior to delivery. This is considerably longer than most indices and creates some unique features specific to this index. The most common is the index's divergence from the price of its underlying asset, which is the cost of natural gas at the Intra-Alberta market. As was stated at the start of this article, the cost of natural gas at the Intra-Alberta Market Centre must be the same no matter how it is priced.
Example
As of April 20, 2004, I could buy gas to be delivered throughout the month of May 04 at a price of $6.1250 CAD/GJ. This is the settlement price for May gas on April 20 as reported by the Natural Gas Exchange (NGX). The current weighted average of all deals done in April to that point was $6.3218 CAD/GJ on a volume of 1.4 MM GJ's. The question is, at what price would you be willing to do an index deal?
I know I can buy/sell gas via the NGX at $6.1250 CAD/GJ (all prices are assumed to be in CAD/GJ). Therefore, any transaction where I am using the index to price a deal has to have an expected price of $6.125. Otherwise the law of one price will be broken and market forces will work their magic to bring the two prices back into equilibrium.
The other piece of information I know is that, in a risk neutral world, the current forward price of $6.1250 is the market's expectation of the price of gas from now until delivery on May 1, 2004.
Armed with this information can I do an index deal without getting laughed out of the market place? Let's seeI could do a deal at index less $0.1968 CAD/GJ. This gets me to the price I know gas at the Intra-Alberta market is worth, $6.3218 less $0.1968 = $6.1250. Mission accomplished. But wait a minute. Suppose one more deal was done between now and the end of the month. We know the price of this deal is $6.1250 because we live in a risk neutral world. We also know this deal will move the current index away from the current $6.3218 and toward the forward price of $6.1250. Therefore, if I am selling gas I'm looking for a job. If I am buying gas I'm looking for my bonus.
Either way, I have just found another clue in pricing my index deal. The only piece of information missing for me to make a guess at what would be a fair price for the deal is, how much more trading activity will take place between now and the index settle date?
Well, if there were no more trades the index would settle at $6.3218 and my original deal of index less $0.1968 would be fair. If there were an infinite amount of trading between now and index settle, I would want to trade at index flat as the current price of $6.1250 would contribute all of the index's weight in the weighted average calculation infinity far outweighs the current trading activity of 1.4 MM GJ's.
So now I have some boundaries. My index deal has to be somewhere between index flat and index less $0.1968. At this point an educated guess is needed to determine the rest-of-month trading volume. If I assume half of the month's volume has traded and another 1.4 MM GJ's will trade from now until settle I get an index price of (6.3218 x 1.4 + 6.125 x 1.4)/(1.4 + 1.4) = $6.2234. Therefore a fair trade based on these assumptions will be index less $0.0984. The actual rest-of-month activity turned out to be 1.25 MM GJ's making index less $0.1041 the best-priced deal given all known information at the time.
The actual index closed approximately $0.2113 below the May gas price making deals done at index less my estimate of a dime pretty expensive. So what happened to all of my analysis and the educated guess of index less a dime? While it was a good guess based on all of the information on hand at the time, it under-estimated the index price because it assumed a May gas price of $6.1250. In fact, gas prices appreciated into the $6.60 range by month's end.
Should our guess at a fair index price have tried to estimate this drift away from the market determined forward price? The answer is no if we assume risk neutrality. Today's forward price should always be tomorrow's expected price unless, of course, you have access to a crystal ball in which case you would be better off picking lottery tickets.
The above example also conveniently assumes away any transaction costs and other incidentals. However, it does provide a good place to start when asking the question, What should the price of an index deal be? Another good place to verify your instincts is the market itself.
The NGX does offer an instrument, the Index Month instrument, that is defined as what market participants are willing to pay above or below index for gas at the Intra-Alberta Market Centre. From this market-traded instrument you can calculate the market implied rest-of-month trading volume and the market's expectation of where the index will settle. But that's another article all together
The CGPR's published NGX - AECO C and N.I.T. One-Month Spot Price Index is a popular way of pricing gas and financial transactions at the Intra-Alberta Market Centre. Its popularity stems from the fact that it is an average priced instrument based on fixed price gas transactions that take place during the month prior to delivery. The averaging helps smooth out the price volatility associated with gas contract as they approach delivery. The index value can be estimated because there can only be one price for gas at the Intra-Alberta Market. Otherwise, the economic principle of one price will be broken. Knowing the price of gas today, and estimating the trading volume that will occur between now and the end of the month, the forward value of the index can be derived and transactions can be fairly priced. Although, when the index settles, you soon realize that some transactions are more fairly priced than others.
If you have questions about this article, contact Mike Busby at MBusby@riskadvisory.com or by calling (403) 263-7475.