What is Basis in the Oil and Gas Markets?
Let’s take a trip back to elementary school:
Teacher: “So, if you have an apple in Georgia worth $2 and the cost to transport it to New York City is $1, how much is the apple worth in New York City?”
Student: “$3”
Teacher: “Well done!”
Believe it or not, this exercise is EVERYTHING you need to know about basis. The Basis Differential for New York City is PLUS $1 to Georgia. Simply put the Basis Differential is the value difference between two locations at a particular moment in time.
Official Basis Definition
Let’s look at a rather official definition according to Investopedia
“Basis differential is the difference between the spot price of a commodity to be hedged and the futures price of the contract used.”
Um, wait – weren’t you talking about apples? Yes – here let’s digest what they are talking about…
When you google crude oil price today – what do you see? You will see something like the following:
This shows what the “Front Month” of Crude Oil WTI is trading – which means it is for a FUTURE time period. So when investipedia is referencing the futures price – all of the financial contracts used for hedging are for future time periods (don’t worry – we will touch on futures and hedging on another post).
Simply put – Basis Differentials are the Locational Price difference (plus or minus) to the location of WTI (which is actually in Cushing, OK).
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Common Basis Points that are used in the Crude Oil Market
Location
|
Basis (Aug-21)
|
|---|---|
Clearbrook, MN
|
($0.25) / bbl
|
Midland, TX
|
+$0.02 / bbl
|
Houston, TX (MEH)
|
+$0.48 / bbl
|
Louisiana Light Sweet (LLS)
|
+$0.66 / bbl
|
Every location in the US has it’s own unique basis. For example, just because you produce a Permian barrel does not immediately equate to getting a Midland, TX Price. There’s often a unique locational variance from a commonly traded point in Midland, TX to the physical location where the oil is being sold.
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Common Basis Points that are used in the Natural Gas Market
Location
|
Basis (Aug-21)
|
|---|---|
Houston Ship Channel (HSC)
|
($0.03) / MMBTU
|
Panhandle
|
($0.32) / MMBTU
|
Dominion South
|
($0.96)
|
TTF (Europe)
|
+$45.15
|
JKM (Japan-Korea Marker)
|
+$12.85
|
Similar to Crude, selling Natural Gas in the Dominion South area, will not equate to a Dominion South price. There is typically some type of transportation involved to sell to Dominion South or to another pipeline in the area (such as TCO which is another commonly traded point in the Marcellus/Utica). But the price at Dominion South will give a directional idea of where the prices will be for that particular area.
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Basis is NOT just the cost of transport between two points.
Quick – how much is an apple worth in NYC?
In our previous example, an apple in Georgia was worth $2 and it cost $1 to transport the apple to NYC which equated to a $3 price, with a NYC basis of $1.
Here’s the “bearish” twist – just because an apple is worth $2 in Georgia doesn’t mean buyers in NYC will pay $3 for an apple. What if cherries were on sale because it is cherry season (which is around April through July or August), so consumers in NYC didn’t care to buy apples at $3 because they could get cherries much cheaper.
Here’s the “bullish” twist – let’s say that all of the transportation trucks have been contracted out in the short term so there’s a shortage of transportation which leads to an escalated transport price of $2 (and it isn’t cherry season) – consumers in NYC might be willing to pay $5 or more for an apple because of the supply shortage. Another example of this might be toilet paper during COVID – prices went up due to supply chain issues.
In Summary:
Basis is simply the value difference between two different locations. A simplistic view would place the delta between the two locations as the transportation cost – but the REAL value difference is matching up the supply and demand both at the origin point and the destination point. This is where fundamental supply and demand is really important for interpreting trends and knowing where the market might go….
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Hopefully, this helps to understand all of these CIA’s (crazy industry acronyms) 🙂
Have a great day!
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