Commodity markets are plagued by confusion as to the relationship between spot and forward prices. There are good reasons. The relationship is not determined by a clean mathematical formula, as it is for example in interest rate markets. In fact it is hard to cleanly define a theoretical relationship between the physical delivery of a commodity and the trading of forward contracts in advance of delivery. This is particularly the case for gas and power markets given challenges with storing these commodities. Instead it is more useful to make observations about the spot vs forward relationship as it is observed in practice.
UK NBP gas spot vs curve animation
The energy industry is typically more focused on analysis of spot prices than forward prices. This is understandable in as much as spot prices drive physical portfolio dispatch and optimisation decisions. But forward price curves are much more relevant from a value monetisation and risk management perspective. It is these prices against which the majority of portfolio exposures are hedged.
One of the problems with analysing forward curves is that a single static curve on its own can be quite a bland snapshot of market conditions. A simple animation provides a more insightful view. Chart 1 shows an animation of the evolution of the relationship between spot and forward curve prices in the UK NBP gas market since Jan 2011. We have illustrated spot prices in the chart with the month-ahead rather than day-ahead contract to remove some of the noise.
Chart 1: UK gas spot price and forward curve evolution
Source: Timera Energy (based on ICE NBP gas futures EoD Settlements). Note, the animation may not work in all browsers (particularly older ones).
As well as being somewhat mesmerising (take care after a long Christmas lunch), the animation illustrates some important curve dynamics. Take two examples:
Spot wags the curve: A characteristic that is particularly common in gas and power markets is the influence of spot price movements in driving ‘parallel’ shifts along the forward curve. Look how prices evolved across 2012 as an example. There are practical physical forces that act to connect the two, e.g. time spread arbitrage via physical storage. But these are not formulaic and interact with a number of other drivers.
Spot price shocks: This year’s summer gas hub price shock provides a good case study of a more extreme disconnect between spot and forward prices. As spot prices began to fall in Q1 2014 the forward curve was dragged down. But as the spot continued to slump into Q2 the forward curve held up (albeit at a lower level to the start of the year). In other words a pronounced curve contango opened up representing a substantial shorter term physical oversupply of gas into NW European hubs (driven by surplus LNG, robust pipeline flows and storage injection limitations). However beyond the current year the back end of the forward curve retained a linkage to oil-indexed contract prices.
These simple case studies illustrate perhaps the two most commonly observed features of spot vs curve behaviour in gas and power markets. But they are by no means the basis for trying to develop an academic theory that comprehensively captures this relationship.
Curve behaviour and market maturity
Prompt vs forward curve behaviour is closely linked to market maturity and the level of commercially optimised intertemporal flexibility (e.g. storage, swing, production flex). Some factors that act as a useful barometer for the maturity of a forward curve include:
Forward horizon – how far ahead of delivery can I trade contracts
Liquidity & transaction costs – what is my access to contract liquidity and my cost of moving in and out of positions (measured by narrowness of bid/offer spreads and market depth)
Contract types & granularity – what types of products are available for me to trade e.g. to manage price shape & non-linear exposures, particularly important for markets with inherent shape and/or flexibility of underlying exposures
Dynamics of forward curve movements – to what extent do different portions of the forward curve move independently from each other
Availability of derivatives – that can be used to manage price risk along the curve with-out having to manage the complexity of physical delivery
As an illustration of different stages of forward curve maturity it is useful to step away from the NBP gas market example and compare:
The Brent crude curve – liquid several years ahead of delivery, tight bid/offer spreads, a range of time spread and options contracts traded and pronounced independent movement along different sections of the curve driven by arbitrage constraints
The UK power curve – limited liquidity out to 3 seasons ahead of delivery, relatively high bid/offer spreads, a limited range of standard contracts and a strong parallel shift relationship between spot and curve movements
As well as the UK power curve being less mature than Brent, these dynamics also reflect a greater difficulty in access to physical arbitrage opportunities for power, given limited storage ability.
Some practical observations on curve behaviour
One myth worth dispelling is that forward prices represent a market prediction of future spot prices. Forward contract prices represent the value today at which paper contracts change hands for delivery of gas over a defined period in the future. The market for forward contracts has its own supply and demand dynamics, driven primarily by the hedging of forward portfolio exposures, but also by other factors such as speculative trading flows.
Spot price events clearly influence the trading of forward contracts as can be seen in the parallel shift case study. This is both via:
Physical arbitrage between spot and forward prices (e.g. “the more cheap spot gas I have to buy and inject into storage now, the more I can sell forward against a future higher price”)
Precipitating rebalancing of supply and demand for forward delivery (e.g. “the price at which I can buy gas today impacts my pricing of gas for delivery in the future”).
Physical arbitrage is the strongest practical linkage between spot and forward prices and an important driver of curve backwardation and contango. Portfolio flexibility options such as swing contract take, storage inventories and production flexibility are all increasingly being managed against forward curve price shape. In more technical jargon, intertemporal flexibility is being optimised against forward time spreads. It is the constraints around optimisation of this flexibility that most closely determines the evolution of forward curve shape. While this is a relationship that can be analysed empirically it is not one that lends itself to a theoretical formula.
