Pricing 101 has returned for part 5 of a 4-part series: we couldn’t leave without addressing the unique complexities of natural gas prices. Many of the ways in which energy retailers cost and price gas tariffs for end consumers will be very similar to electricity, but the fundamental physical differences between the two types of energy mean that they are not identical. Parts 1-4 of this series used electricity as the default, and so in this final part, we will explain how gas pricing works in the US.

The Basics of Gas

As with electricity, natural gas was a once vertically integrated market that was broken up into separate functions. Energy retailers sell gas to residential and business customers through pipelines, measuring consumption with meters and charging based on consumption. It is further up the chain that the differences arrive.

Natural gas is a commodity which can be produced nationally and internationally. The US has largely avoided the spikes in wholesale gas prices that have plagued Europe due to the fracking boom; Europe was reliant on gas delivered from Russia before the Ukraine war halted this flow and was even assisted to some extent by liquified natural gas (LNG) exports from the US. Tracking fluctuations in wholesale gas prices is a bit easier compared to electricity as you are just measuring one commodity, which can be delivered either through pipelines or as liquid natural gas for overseas transportation.

In part 1 of this series, we used the following diagram to explain the structure of energy:

However, the likes of microgrids, distributed energy resources, and on-site generation do not apply to gas as a physical commodity. Transmission cables are replaced by pipes and batteries by physical storage containers. This makes things simpler in many ways. The wholesale market price for US gas is (largely) determined at NYMEX (New York Mercantile Exchange), but the gas itself is delivered from regional hubs, the most important being Henry Hub in Louisiana.

This gives a fairly stable national price for gas, although there is locational pricing on top of that depending on where the gas is delivered. A local market will offer a price that is based on a price emerging from Henry Hub, with adjustments for transportation cost, pipeline capacity, as well as regional market conditions. As the most significant use for gas is heating in most of the country, demand shows significant seasonal fluctuation, with winter demand much higher than summer - in summertime, gas will often be used to generate electricity as it fuels over 40% of the power generated in the US as reported by the EIA (US Energy Information Administration).

The Complexities 

Unlike electricity, gas does not lose (much) volume through transmission, allowing transcontinental pipelines to cross America from Henry Hub. However, fuel losses do occur at offtake points which must be accounted for. Pipelines have capacity limits, which means retailers need to know how much gas will be flowing from one point to another, and how much capacity they must reserve in the pipelines.

Utilities will have allocated space in pipelines, but will also have to buy space on the day, giving two different transport prices - the day-ahead price is larger. Big customers can also secure their own pipe capacity, which is treated at the allocated price. If retailers allocate more pipeline space than you need, the excess is treated as an asset for them. All of this is calculated at the utility level and not the meter level like with electricity. Depending on which pipelines are delivering gas, different loss rates will apply. This can result in blended losses.

Now we come to pricing, and things get even more complicated. A business customer purchasing gas will need to decide on three factors: Product, option, and term.

• Product determines the pass-through price for the gas itself. NYMEX, as mentioned above, is the price for gas at Henry Hub. Index is instead based on the gas price at a specific region of the country. The index may be a daily index, such as Platt’s Gas Daily, or a monthly index such as Inside FERC. The index point selected may be at the Henry Hub, at a pooling point, or at a gated “citygate” point. There are dozens of liquidly traded, regional index points which represent the cost of gas delivered into different market areas. Both NYMEX and Index are traded monthly. A Fixed price, meanwhile, allows you to secure a set price per unit for a longer period of time, fixing both the commodity price and transportation costs.

• Option determines how customers will pay for the physical costs of delivering gas, including transportation, storage, and any local production. For NYMEX contracts, this is often called “basis”.
• ‍
• Term is the length of the contract. This will typically be 12 or 24 months, but retailers are free to offer contracts of any length.

A retailer may take each of these options and provide business customers with a matrix of prices for a quote. This represents quite a significant calculation and can be a barrier to efficient pricing.

However, the price does not stop there. As mentioned, transport prices are based on purchasing space in pipelines, with some purchased ahead of time and some on the day. Tiered pricing works through this allocated and purchased capacity. The more expensive purchased capacity has a higher price. Customers can either be single price for everything, or pay for allocated and procured separately

Before a customer is offered a price, the retailer itself will also need to add on its margin. How this is calculated will depend on whether the retailer is using a bottom-up or top-down approach. Thus far, we have been describing a bottom-up approach to pricing, in which the retailer calculates all relevant costs before adding a suitable margin to the total. A top-down approach starts with a price, and works backwards to determine if a retailer can offer this price profitably. 

Neither method is the “right” pricing method, each one has its pros and cons. Bottom-up pricing gives certainty to the retailer and makes it easy to calculate profit margin on any tariff. However, bottom-up prices may be uncompetitive and could lead to retailers being caught out by market dynamics. Top-down pricing will guarantee a rate that is competitive to the market, but comes with a greater risk.

There is one surefire way to price that avoids the downfalls of either method, which is just to do both. Calculate a top-down and a bottom-up price in parallel - an approach that Gorilla has helped to facilitate but probably wouldn’t work on legacy systems.

Summary

Like electricity, natural gas was once managed and sold by vertical monopolies that handled everything from sourcing to delivery. Now, in competitive states legacy utility companies have been split up and the role of pricing and billing for gas falls to energy retailers. 

For an end consumer, the pricing of gas will look similar to electricity, with a meter measuring consumption and consumers paying an amount based on that. However, for the retailer things look very different. There is no network of generators offering different prices at different times. Instead, wholesale prices are largely determined by NYMEX, and gas itself is sourced at major hubs like Henry Hub. Distribution and transmission costs for energy find their equivalent in the cost of securing pipeline space for gas.

When a retailer is costing and pricing up a natural gas tariff, they will need to know several things. First, the wholesale cost that the customer wants - they can pay monthly NYMEX prices, monthly local prices (known as Index) or fix the wholesale price. They must also decide on the length of their contract, and how they will handle payments for transportation and other costs of delivery.

At the end of this process, retailers will also need to account for their own margins, which they can do via a top-down or bottom-up approach. All of this represents a major technological challenge, requiring powerful data processing to deliver quotes to customers that are fast and accurate. Gorilla has been helping gas retailers in the US and across the world to take control of these issues and stop the patchwork of solutions.

Ready to hear the story of gas pricing from the retailers themselves? Check out our webinar with Southstar:

When 1+1=3: SouthStar and Gorilla's Formula for Energy Retail Success