Volume flexibility in European gas contracts26 Sep, 2011
In the order of 70% of European gas is sourced through long term contracts with producers. As a result, the pricing and volume flexibility of these contracts are key drivers of European wholesale gas market dynamics. There are a diversity of counterparties, flexibility constraints and pricing structures. But the majority of contracts are based around a standard set of terms defining gas volume flexibility. In this article we outline those terms and explore their impact on contract value and volume exercise. We will then follow up with subsequent articles looking at some of the more complex aspects of gas contract valuation, optimisation, hedging and hub interaction.
Standard contract volume terms
If you are familiar with the standard volume flexibility terms of a European gas contract you may want to jump to the next section. If not then a high level definition of the key volume terms common to these contracts is provided below:
Volume units: Contract volume is typically defined by referring to Annual Contract Quantity (ACQ) and the Daily Contract Quantity (DCQ) as units.
Maximum ACQ: The maximum permitted annual contract take (usually defined as a % of ACQ) also known as Maximum Annual Quantity.
‘Take or Pay’ volume: The minimum annual volume of gas that must be paid for, although not necessarily taken (also known as the Minimum Bill).
Maximum and Minimum DCQ: The maximum and minimum daily volume of gas that can be taken.
Make Up: The ability to bank a volume of ‘Take or Pay’ gas that has been paid for but not taken. Make Up gas may then be taken in a subsequent year, typically once conditions around the Take or Pay obligation have been met in that subsequent year.
Carry Forward: The ability to offset payments for gas take above Take or Pay volume in the current year, against Take or Pay volumes in subsequent years.
The impact of volume flexibility on intrinsic value
The negotiation of gas contract volume constraints (e.g. Take or Pay, Max DCQ, Max ACQ) is an important driver of contract value. To gain an overview of the value impact of each individual volume constraint, it is useful to consider the impact of the constraint on the intrinsic value of a contract, the value that can be hedged at any point in time against prevailing forward market prices. The primary drivers of a gas contract’s intrinsic value are:
- The relationship between the contract strike price and forward gas prices
- The seasonal shape of forward gas prices
- The flexibility of contract terms in allowing the annual contract volume to be ‘shaped’ into higher price periods.
To explore the value impact of contract volume constraints, it helps to assume that the contract price is fixed. In reality the contract price is likely to be determined by the evolution of an oil-indexed price formula (which can anyway be hedged as we set out here) but we come back to this complexity later. Table 1 illustrates an example of an ‘In The Money’ (ITM) gas contract with a strike price below prevailing forward market prices.
An ITM contract typically has the greatest value sensitivity to changes in the Max DCQ constraint. An increase in Max DCQ allows the contract owner to shape more of the annual contract volume into the higher priced winter months. The value impact of doing this is clearly a function of seasonal price shape. Decreasing the Min DCQ on the other hand results in a re-allocation of gas across the lower priced summer months with a relatively low value impact. Increasing the annual contract volume (ACQ), means that more gas is taken in the ‘marginal’ month of August, the highest priced month where the Max DCQ constraint has not been exhausted. Similarly changing the Make Up volume will typically impact the decision to flow gas from a marginal month in the current year versus a year in the future.
An ‘Out-of-The Money’ (OTM) contract, where forward prices are below the contract price, exhibits a somewhat different value sensitivity to changes in volume terms. The owner of an OTM contract is typically more concerned with the Min DCQ constraint. A reduction of Min DCQ allows a reshaping of the Take or Pay volume away from the more painful low priced summer months. Changes in Max DCQ on the other hand have a relatively low value impact as they only affect the short period of the year when the Max DCQ constraint binds (Jan-Feb in the example) in order to satisfy the Take or Pay volume.
It should be noted that the contract used in the examples exhibits a reasonably high level of volume flexibility. There are many long term European contract structures which allow a lesser degree of volume swing between max/min ACQ and max/min DCQ.
Looking past intrinsic value
Intrinsic value is a useful starting point for understanding the impact of volume flexibility. Indeed many European gas contract owners hedge and optimise their contract gas take based on intrinsic value, although usually by implementing a ‘rolling intrinsic’ strategy where dynamic adjustments are made in response to changes in market prices. But to fully understand the drivers of gas contract valuation it is important to understand and manage the extrinsic value associated with the contract.
Extrinsic value is derived from the ability of the contract owner to use contract flexibility in response to changes in market prices. As such it depends on three key factors:
- The contract volume flexibility defined by the volume constraint terms
- The ‘in the moneyness’ of the gas contract (ie the relationship between the strike price and prevailing forward market prices)
- The volatility of gas market prices, specifically the volatility of the time spreads between different time periods across the year.
Greater contract volume flexibility allows the contract owner greater freedom to move volume from low to higher priced time periods (time spreads). The value derived from this contract volume flexibility (or time spread optionality) depends on the volatility of the market prices against which gas volumes can be monetised. In turn the value of flexibility to move gas between time periods depends on the contract versus market price relationship across those periods (extrinsic value is typically highest for ‘at the money’ time spread optionality).
Extrinsic value can be captured to some extent by using a ‘rolling intrinsic’ hedging strategy, where intrinsic value is hedged and then hedges are adjusted as higher value opportunities arise. Alternatively a more sophisticated ‘delta hedging’ strategy can be used based on probabilistic (stochastic) modelling of the evolution of gas market prices.
Gas contract hedging and optimisation is complicated by oil price indexation. While oil indexation is convenient for upstream producers, extracting the value of contract flexibility can depend on deconstruction and management of a complex basket of gas, oil and exchange rate exposures. The relationship between the price indexation terms and optimisation of volume flexibility is a key value driver. It is interesting to note that the recent gas indexation negotiated by some contract buyers, while simplifying contract optimisation, can act to reduce the value from flexibility to shape gas into higher priced periods.
Gas contract flexibility will be an increasingly important issue for the industry, given the growing requirement for European gas flexibility and the extensive re-negotiation of contract terms currently in progress. This article has only touched on some of the more interesting issues associated with the value of gas contract flexibility. We will return to explore some more practical examples of contract optimisation, hedging and hub pricing influence in follow up articles.
Bleeding value from residual foreign exchange risk (case study on oil indexed contract pricing)