Price Risk Management: Electric Power vs. Natural Gas

Fortnightly Magazine - February 1 1996
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The deregulated power market will feature large numbers of buyers and sellers. Buyers will worry that prices will rise unexpectedly above current levels; sellers will worry that prices will fall unexpectedly. Some will be interested in fixed-price forward deals that protect them from these risks. Retail marketers will want to offer fixed prices to customers for one or several years.

Power marketers will be especially interested in risk management, because offering forward price deals will make up an important part of their business. In particular, they will be interested in understanding the sources of power-price volatility and available mechanisms for managing this risk.

Nevertheless, despite predictions that electricity and natural gas will converge into a single, unified

energy market, many significant differences will likely remain between these two commodities, especially in terms of price risk and uncertainty.

The gas market is conducive to a futures market. Many parties are concerned with either unexpectedly low or high prices, and hence, very interested in nominal fixed prices. Production is also concentrated regionally to a high degree. The great majority of production lies in the Texas, Louisiana, and Oklahoma area, such that a central regional hub, the Henry Hub, has emerged as the dominant and reasonable basis for a stylized futures contracts. Such contracts are of interest and make sense for enough players to support trading on a public exchange.

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