Technological advancements allowing for an influx of shale gas have been the liberator of the U.S. natural gas industry. But the surge in shale-gas production is redefining the landscape for basis differentials.

Production potential has overwhelmed the market and ironically, experts are now asking for a moderation in production, which stands at a little less than 60 billion cubic feet (Bcf) per day, with proved gas reserves seeing the highest increase in history.

Depending on timing and one's orientation in the industry value chain, the plethora of gas could either be a blessing or a bane for natural gas prices. Prices should be viewed in two fundamental but connected ways, depending on perspective—first, either at or relative to a major reference point into the future; and second, via the relationship of a minor point to the major reference point at a particular time.

Henry Hub prices, the North American standard reference point, have steadily declined over time due to a supply/demand fundamental disconnect. Also, there has been a progressive flattening of the seasonal contango (pre-winter) and backwardation (post-winter). Prices are expected to stay low, entailing fewer opportunities for short-term arbitragers and market participants acting on forward spreads.

Natural gas basis, the second way to view pricing, is the difference between a regional hub and the Henry Hub, or the opportunity cost to move natural gas between hubs. Basis is not solely dependent on pipeline tariffs, but it is strongly correlated to pipeline capacity and utilization rates.

When there is excess capacity on a flow corridor between hubs, regardless of whether a particular integral pipeline on the flow corridor is at full capacity, basis will remain low and approach pipeline variable costs. Basis can increase abruptly far above maximum tariff levels when utilization rates are approaching 90% or more. Building pipeline-transmission capacity will reduce basis and also price volatility between regions.

With more than 276,000 transmission miles, the U.S. pipeline network is the most evolved and intricate in terms of system connectivity. Additional construction due to the shale influx will add more efficiency to the system. An estimated 3,243 miles of pipeline were planned for 2010, and the expectation for 2011 is comparable—not to mention an estimated 163 Bcf of underground storage capacity added in 2010.

Due to future pipeline builds, aggregate pipeline-utilization rates for demand-driven flows will ease, and basis for hubs will not only narrow and stabilize but also become less volatile.

Basis volatility is abated in part by the sporadic geographical distribution of unconventional resources. Market points that represent regional hubs will cover larger physical areas, and a closer interconnectivity between multiple market points will dampen the effect of transient interruptions at any one point.

Going forward, the basis market is going to be fairly bland, lacking the regular kick of unexpected swings in regional price differentials that the North American market has experienced in the past decade. Derivative positions by marketers and traders, who once used to take advantage of this inefficiency, will be gradually sidelined.

Release of pipeline capacity to third parties for arbitrage purposes will be less prevalent. Long-term pricing contracts will seem more attractive to industrial- and power-sector users. Even though basis risk will not be eliminated, both absolute prices and basis volatility will be diminished.

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