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Chapter 7: NYMEX Energy Markets and the Use of Environmental Data | Data for Science and Society: The Second National Conference on Scientific and Technical Data | U.S. National Committee for CODATA | National Research Council

U.S. National Committee for CODATA
National Research Council
Interdisciplinary and Intersectoral Data Applications: A Focus on Environmental Observations
 


7

NYMEX Energy Markets and the Use of Environmental Data

Bradford Leach




     Good morning. I am director of electricity and natural gas research with the New York Mercantile Exchange (NYMEX). Since 1986, I have been involved in the development of various energy futures and options contracts. The ultimate economic test of new and existing futures contracts is whether these markets are useful to commercial participants. The research department that I am part of is focused on developing futures contracts through understanding commercial business practices in the underlying physical markets.

     NYMEX, as a financial institution, dates to 1871 when agricultural products were critical to the U.S. economy. We have seen a dramatic product shift over time, and today our primary focus is on energy commerce. NYMEX now has two divisions, the NYMEX division that includes the energy contracts and the COMEX division, which includes metals contracts. Our COMEX division was a separate exchange until 1994, when it was acquired by NYMEX.

     The primary activity at NYMEX derives crude oil, natural gas, heating oil, and gasoline--a critical complex of commodities that launched NYMEX into a position of high visibility. The development of the natural gas futures contract took more than 7 1/2 years from start to finish. We had an enormous changeover in the interstate regulatory structure that led us from one individual market in an isolated part of the country to a construct that is useful to at least 60 to 70 percent of U.S. natural gas commerce. This was a significant shift, and it illustrated how important it is to understand changes in commercial practices, which can affect the underlying viability of proposed futures contracts.

     Environmental factors are a critical area for NYMEX given the energy contracts, which are directly affected by environmental data. This is true for all energy contracts, but particularly for natural gas and electricity. Due to this importance, it is critical that we understand data availability issues as we measure the operation of the markets.

     On March 2, 2000, we shifted our electricity complex to the NYMEX ACCESS trading system, which provides an electronic futures trading marketplace. Previously, NYMEX ACCESS was provided only for off-hours trading when the NYMEX floor was closed. Figure 7.1 shows the growth that NYMEX has had over the years. We have grown from about 15 million contracts traded per year to about 90 million in 1999. The fundamental reason for this growth involves the use of our contracts for risk management. This is an important economic function and is critical to the success of NYMEX markets.



Figure 7.1

   


     NYMEX also provides a price discovery function. Previous to the start of NYMEX natural gas futures trading, the only way to determine the value of cash natural gas was through newsletters and publications, which covered only the balance of the current month and the upcoming month. Markets need more pricing information than this to develop efficiently. When the NYMEX natural gas futures contract started trading in 1990, pricing related to 12 consecutive months became available. Well-developed competitive markets require pricing information to help make economic decisions related to the underlying commodity. Given this, price discovery is a key function that NYMEX provides. Prices from our contracts are disseminated to thousands of sites around the world and form benchmarks for determining the value of commodities in trade.

     Another major NYMEX function is the clearinghouse. What do the clearinghouse functions provide? We provide a means to take the financial risk out of the transaction. We do this by having a detailed margin system in place that ensures the financial security of all contract positions at NYMEX. This is done through multiple layers of protection. We also have a guaranty fund to protect against credit problems with individual clearing firms. In addition, we have position limits in place for all of NYMEX markets. Position limits simply mean that individual commercial entities can hold only a certain number of positions in contract trading months. Additionally, the NYMEX Compliance Department operates market, trade, and financial surveillance programs, which ensure fair and orderly market operations.

     We also have standard delivery rules for our futures markets. What does this mean? It simply means that market participants can obtain physical delivery through their futures positions provided they have an appropriate level of commercial expertise. Only a small number of contracts transacted at NYMEX result in standard delivery. For example 0.3 percent of total natural gas futures contracts resulted in standard delivery in 1999. However, due to the high underlying liquidity of this market, the result was approximately 3000 contracts per average month. It is very important for commercial markets to have a financial risk management mechanism that works well and efficiently through transparent procedures and pricing. Physical delivery is an important part of the value that NYMEX offers.

     The research department's responsibilities involve understanding physical processes in the industry, which means visiting scheduling control rooms and talking with engineers, going to platforms, and visiting critical data centers. It is all part of the process of learning about the physical market, which many of you do every day in the scientific arena. It is very important that we understand how the underlying physical mechanisms work in the commodities we serve. We cannot regulate what we don't understand. So it is very important that we have this working knowledge.

     The research department has two major foci. One is contract maintenance. This simply means that once we have a contract in place, we continue to study the way the market is operating so that when commercial changes take place--when the Environmental Protection Agency, for example, sets a different standard for gasoline--we understand how it is going to affect our contracts tomorrow. If we don't understand these things, there can be disruptions in the market, so we make a real effort to focus on understanding changes in the environment and changes in the commercial practices that may affect how markets are used. We take this information and make appropriate changes in the contracts. A futures contract can be a work in progress as long as the industry is evolving through changes in commercial practices.

     The second critical function of the research department is new product development. Ideas for new products come from a number of different sources. The important thing is listening to the commercial world to get its ideas and research and to move things forward through our advisory committee functions. We have advisory committees for all commodities that we operate. Once a commodity is identified as suitable, we typically organize an industry advisory committee. The intention is to include many representatives from various sectors in the commercial world to give us input on the contracts we are trying to develop. NYMEX uses the advisory committee process rigorously and creatively in the development of contracts.

     What are some of the elements that we examine when we get new markets? One is the degree of standardization and efficiency in the proposed new market. Markets that are subject to month-long negotiations for transactions typically do not develop significant liquidity, so we look for new markets that have a level of standardization suitable for market development. At one point in our history, we would typically wait until there was suitable level of activity in the underlying markets and then develop a futures contract. Our environment is much more competitive these days; the luxury of waiting for a preset level of liquidity has become less important. In fact, we have been able to offer our market knowledge to federal and state regulators in their electricity deregulation proceedings during the development of this market.

     Today, we build contracts to serve developing markets and ensure that these contracts grow along with the cash market through research into evolving cash market practices. We study the operation of the cash market through contacts with each subsector of an underlying industry to understand how an underlying market operates. We then take this knowledge and try to distill it to a set of terms and conditions that become the standardized futures contract.

     The natural gas market has extreme sensitivity to environmental data. An analysis of price information from launch of the contract in 1990 to the present indicates an average annualized volatility of approximately 50 percent. The average for the petroleum complex over the years has been well below this volatility level. Weather information is critical to the value determination of natural gas.



Figure 7.2

   


     Figure 7.2 includes a number of different reports that the market looks at regularly. The American Petroleum Institute (API) storage reports are especially critical because of the high value involved. There are many people who make use of the statistical bulletin generated by API as a measure of how much gasoline is available to the market in different petroleum regions in the United States. This is valuable information and it helps the commercial community put a value on gasoline and other products. This information is critical for market efficiency, and it must be real-time information. We heard about real-time data this morning, and I want to add my voice to this issue. It is very important that the reports not only be based on historical background, but also be used and useful in today's real-time environment. As a society, it is ultimately beneficial to have more information assimilated and continually updated so that we can distill all this information down the highest level of efficiency for pricing purposes.

     The American Gas Association (AGA) natural gas storage report is another important supply report. Before the AGA storage report was published, there was only a monthly report that was 2 _ months out of date. Now, suppose you are an industrial user seeking to make a decision about the natural gas transactions going into winter. How useful would a report be that is 2 _ months old? Obviously not very much, so AGA developed a weekly survey. Every Wednesday, the market gets the storage levels that are reported by AGA members available for the marketplace, and this adds to the economic efficiency of the price of natural gas.

     The Baker Hughes report, which shows the total number of rigs in place, is useful from the standpoint of understanding natural gas production. It is another source of information that is useful to the market. The National Oceanic and Atmospheric Administration 6- and-10-day weather report is another critical benchmark for electricity and natural gas. It is important that the marketplace trust this report as impartial and subject to scrutiny as being statistically valid. In addition, it is very important that these elements are satisfied for the market to make use of such reports.

     Weather data are now critically important in energy contracts. NYMEX contract research extends to multiple sectors of the economy, not just energy. A continuing NYMEX goal is to identify developing areas of the economy that require risk management and price discovery in order to develop futures and options contracts that fulfill these economic functions.



Copyright 2001 the National Academy of Sciences

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