The New York Mercantile Exchange (NYMEX) is the world's largest physical commodity futures exchange and the most important trading venue for energy and precious metals. NYMEX was a pioneer in the development of energy futures and options contracts 30 years ago, as a means of bringing price transparency and risk management to the energy market.

NYMEX provides markets for the trading and clearing of more than a dozen energy and precious metals commodities, including natural gas. It is a regulated entity that functions as an anonymous clearing house, i.e., a common counterparty for all exchange participants, both buyers and sellers. It has rules governing such things as margin calls and membership fees, and it removes the issue of creditworthiness among members.

The Exchange traces its roots to the middle of the 19th century, when traders began organizing market forums to make the buying and selling of commodities easier. The markets also allowed participants to set quality and quantity standards and establish rules of business. By the late 1800s there were about 1,600 exchanges in the U.S., most located at important transportation hubs. Today, only six remain.

During the Great Depression, the Commodity Exchange was formed through the merger of four smaller exchanges. Sixty years later, the New York Mercantile Exchange combined with the Commodity Exchange to form today's NYMEX. While NYMEX rules still allow the physical delivery of traded commodities through the Exchange, that rarely occurs. Instead, traders buy and sell natural gas and other commodities through instruments called futures contracts.

Futures contracts are standardized to guarantee that prices mean the same thing to everyone: traded contracts all share the same specifications for quality, quantity and delivery location. Prices are set through a bid/ask process (the same way the stock market works), and futures contracts are most commonly used for hedging, or offsetting the risk of fluctuating prices.

The transparency of NYMEX prices and the integrity of its markets make NYMEX a widely accepted and reliable benchmark for energy pricing. Ultimately, NYMEX officials say, the benefits of this marketplace accrue to energy consumers, who receive prices based on open and fair competition.

NYMEX-traded futures contracts for natural gas are based on physical deliveries at Henry Hub, in Erath, Louisiana. Henry Hub interconnects with nine interstate and four intrastate pipelines. Spot and future prices set at Henry Hub are generally regarded as the primary price set for the natural gas market in North America.

NYMEX futures contracts represent only a segment of Henry Hub-traded products. "A significant amount of Henry Hub forward contracts, which are settled financially (no physical delivery of molecules required), are executed via the Intercontinental Exchange and other over-the-counter (OTC) bilateral contracts between various market participants," explains Tim Ray, Vice President, Gas, Southern Region, at Direct Energy.

During the past 10 years, Henry Hub prices have continued to trend higher as domestic supplies have declined. The primary reduction in supply has occurred in the shallow waters of the Gulf of Mexico, where current daily output is just half that produced in the late 1990s. At the same time, use of natural gas to produce electricity has exploded.

"The net result of this has been the need to balance the U.S. natural gas market via increases in natural gas imports and a stark reduction of industrial end-use consumption through price increases," Ray says. That has led to a 40% increase in the amount of liquefied natural gas (LNG) imported into the U.S. last year, and international demand for LNG is also on the rise.

Through the first four months of 2008, declining U.S. inventories of natural gas coupled with increased global demand for LNG supplies resulted in domestic prices spiking upwards about 45% from year-end 2007 levels. "The question remaining for U.S. market participants is whether current domestic drillers can grow the supply base enough to offset the projected reduction in U.S. LNG imports this summer," notes Ray. He adds that other factors, ranging from potential hurricane impacts to localized conditions at domestic supply trading points other than Henry Hub, may also affect natural gas pricing.