Published Price Indices

as the Basis

of Federal Royalty Payments

Prepared For

NATURAL GAS SUPPLY ASSOCIATION

Prepared by

FOSTER ASSOCIATES, INC.

Washington, D.C.

December 1995

EXECUTIVE SUMMARY

Today's gas market can be characterized as a classic example of a competitive industry: many buyers competing to purchase a homogenous commodity from many competing suppliers. This process results in a truly competitive price, a market clearing price.

Several trade journals survey buyers and sellers of natural gas, and report first-of-the-month weighted average prices negotiated during bid week for the month's transactions. These reported prices are commonly called monthly index prices. The purpose of this report is to determine if these monthly index prices are representative and accurate measures of the market value of gas.

Foster Associates analyzed the index prices reported by three widely circulated trade journals: Natural Gas Intelligence (NGI), Natural Gas Week (NGW) and Inside F.E.R.C.'s Gas Market Report (IFGMR). Foster's analysis of the monthly index prices published by these journals revealed that the reported index prices are generally reliable:

(1) Annual averages of the first-of-the-month index prices generally equal the annual "after market" monthly prices. There were, however, small seasonal biases. The after market prices during the offseason (summer) were slightly ($.01 to $.02 per MMBtu) lower than the index price; the opposite was true during the winter months.

(2) The indices for comparable price quotes for delivery to specific pipelines published by the three journals were generally the same.

Foster Associates found that published price indices represent actual market prices. First, since index prices are determined by survey of actual first-of-the-month transactions, they are by definition representative of actual market prices. Second, in today's market, index prices are also generally used to establish firm (term) gas prices because their contract pricing provisions tie the commodity gas price directly to a published monthly index. As a result, the published indices have become the market's benchmark prices.

It is evident, based on LDCs' filings with their respective state regulatory commissions, that most long-term firm contracts have a two-part pricing provision, a commodity purchase price and a reservation charge. The two pricing provisions reflect the two functions performed under these long-term contracts. Gas supply is sold at the commodity value, generally at the monthly index, and the reservation charge reflects other services performed under the contract, such as swing or take flexibility, reliability and/or security of supply, aggregation, and transportation and other related services. The commodity purchase price is tied directly to the monthly index price, or negotiated monthly with the index price as the backup if negotiation fails. Thus, spot prices are generally representative of the commodity value of the gas sold under term contracts.

Foster Associates' research reveals that buying practices use index prices as a pricing basis. We compared published monthly index prices with actual prices to determine how well the indices represent the current gas market. The first comparison is with reported gas prices paid by utility power plants in the Gulf Coast area and other markets, and the second comparison is with prices reported to the MMS for the purpose of royalty determinations.

The gas values reported to MMS are a far more relevant comparison because these supplies are those "in question" with respect to appropriate royalty values and the underlying transactions are actual prices received. With respect to these data, Foster Associates conducted two statistical tests between the actual prices and the published indices: (1) a correlation analysis and (2) a revenue neutrality test.

Foster Associates found an extremely high correlation between the index and actual prices reported to the MMS: for 35 separate producing areas tested in the OCS and Rocky Mountain areas, well over 90 percent of the changes to actual prices are directly measured against changes in the index. Statistically, this means that the actual price changes can be "explained" by the variations in the price index.

The second test, the revenue neutrality test, compared the actual revenues with revenues estimated on the basis of the index price. The results showed that for the OCS, the revenues estimated using index prices were virtually identical to actual revenues. However, the comparisons of actual prices with published offshore price indices were made without transportation cost allowances. If we were able to make this comparison with a transportation cost allowance, the royalty values based on indices would probably be slightly higher than the royalties based on actual prices. This occurs because the transportation cost deductions to the actual price, being determined to onshore points, are higher than the transportation cost adjustments for the offshore pricing (index) points.

In the Rocky Mountain and San Juan areas, revenues estimated using index prices were slightly higher than actuals. In the Rocky Mountain areas, the sales point is generally the same point as the published price indices. Therefore, prices on which royalty determinations would be made would be lowered via the same transportation deduction whether using the actual prices or the index prices.

In conclusion, Foster Associates found that published index prices are good indicators of today's gas market prices. The index prices are not only representative of the spot gas transactions (about 30-40 percent of the market), but are also the general commodity pricing determinants for long-term firm contracts. Statistical tests prove that actual prices and index prices are highly correlated. We conclude that the use of published index prices in calculating royalty payments for gas sold under non-dedicated contracts (in lieu of actual prices) would not reduce royalty payments to the MMS.

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This page was last updated August 31, 1997.