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Price Risk Management: Electric Power vs. Natural Gas

Fortnightly Magazine - February 1 1996

historical estimates proved no guide to current conditions. Figure 1 shows our assessment of the market price volatility for PSNM, based on engineering economic fundamentals. Second, analysts may not find enough historical data.

Fundamental Analysis:

An Alternative Approach

An alternative approach relies not on historical data, but on engineering and economics to assess the distribution of future prices. In the natural gas and other markets, fundamental analysis is used to supplement other information. Fundamental considerations can be assessed informally or use more computer-based market modeling.

In the case of gas, market modeling would rely heavily on reservoir engineering simulations and assessments of demand. In the case of power, modeling would be based on an analysis of power plant dispatch. By varying key parameters and associating a probability to each state, a probability distribution of key prices (and other parameters such as standard deviations) can be developed.

Market Weaknesses:

Rewriting the "Book"

To understand the limitations of futures contracts that gas marketers are experiencing, it is useful to review the two conditions that underlie the futures-oriented, gas-procurement approach. First, there must be a high regional concentration of gas production, so that the Henry Hub makes sense as a basis for a futures market. Second, there must be sufficient capacity on the transmission system for marketers to back up their offers for fixed nominal prices at other nonhub locations with physical delivery.

These two conditions are still in place but not fully so. The West South Central producing area is expected to continue to be the largest producing area, consistent with the conditions that led to the Henry Hub. However, forecasts we have made using our supply-based gas industry reservoir simulation models indicate a steady shift of production to the Rockies and nearby areas. By 2010 we expect that area to run a very close second.

At the same time, transmission limitations restrict the movement of gas from West to East. These restrictions may not be relieved at a rate commensurate with the increasing supply from this region. If the restrictions are not resolved, the price at a given location will deviate from the hub plus transportation price, gas transmission capacity to link the markets will be inadequate, and the marketer will be unable to back up offers with physical delivery.

This problem could be solved without the marketer taking uncovered positions:

s Create a balanced regional "book." Marketers could create a book of transactions with local area suppliers and buyers that match or nearly match. In such a case, all sell commitments are offset by buy commitments, and the marketer is protected from price risk.

s Create a regional futures contract. If the volume of transactions is high enough, one could even create another futures contract to be traded on an exchange in which the delivery location was the nonlinked region. There have been recent steps in this direction (e.g., the recently established Kansas City Gas Futures). If sufficient regional exchanges are available, marketers can become fully protected from price risk.

The Casino vs.

the Forward Price Curve

Creating new regional "books" to