What Is the Difference Between the Physical & the Derivative Natural Gas Markets?

Gas supply begins with physical production from a gas well. Conventional gas production involves tapping gas stored under pressure in a reservoir rock. Gas rises to the wellhead under its own pressure or with the aid of the injection of water or other fluids. Shale gas -- unconventional gas -- is natural gas trapped within shale formations. It is released when this rock is fractured. There is no physical supply of gas to the derivative markets.

Natural gas demand is the physical level of overall gas consumption at a particular time by residential, commercial and industrial gas users. Gas demand varies with the weather, a surplus or lack of supply, environmental regulations, economics, and technology. Winter heating and summer air conditioning involve higher gas use. Gas demand declines with the use of energy efficient housing and appliances, and during economic recessions.

Gas prices depend on supply and demand. There are few short-term alternatives to natural gas or electricity for heating, so prices can fluctuate widely. The spot market price is the gas price for physical delivery on a particular day. The futures price is the gas price stipulated for physical delivery of gas on a future date. In both cases, the price refers to physical delivery at one a few dozen locations in the United States called hubs, where major gas pipeline systems interconnect. Henry Hub in Louisiana is the largest. Gas derivatives traders use these gas prices as the basis of their contracts.

Physical gas is traded through contracts between buyers and sellers, often involving intermediaries. The parties agree to deliver or to take delivery of a specific volume of natural gas over a particular period at a given price. There are three types of physical contracts. Swing or interruptible contracts are flexible agreements that do not oblige either party to deliver or receive exact amounts. Baseload contracts state that the parties will make “best efforts” to deliver or receive gas. Firm contracts legally oblige the parties to receive or deliver gas.

Traders in the derivatives gas market acquire a payout in exchange for a payment. They use financial instruments such as swaps and options that base their value on natural gas prices. A swap involves the exchange of income flows from earlier transactions. Options give the buyer the right but not the obligation to sell something at a particular price. These contracts may be traded privately between market players as over-the-counter derivatives, or on an exchange such as NYMEX.

Physical market traders risk large financial losses from gas price volatility. They hedge this risk on the derivative markets. Financial traders use the gas derivatives markets to speculate on price movements. They do not need to have any interest in any buying or selling of the gas.