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Price Risk Management: Electric Power vs. Natural Gas

Fortnightly Magazine - February 1 1996

link buyers and sellers or using new futures contracts may not work in many cases. The volumes may not be sufficient to justify the costs of a public exchange or to prevent players from manipulating the market price (e.g., cornering the market). Books also require a minimum volume and the process of starting and maintaining a book may require taking

uncovered positions. An alternative solution (or a complement to a book) would be to create a forward price curve in which the key element is not a futures market, but market-makers that take this risk for a fee (em e.g., the marketer.

The market-maker's activities can be contrasted to those of the operator of a casino. The casino operator knows the outcomes of his game. For example, in the case of an "even" roulette table, half the outcomes would be red (i.e., the operator pays a given amount) and half the outcomes would be black (i.e., the player pays the same amount). Although the operator could have a winning streak (many blacks in a row) or a losing streak (many reds in a row), on average he breaks even. In other words, the casino operator manages risk by having enough volume that the law of large numbers will ensures a profit at the expected rate.

In casinos, the margin is set in large part by competition between casinos and by customer response to the margins. For example, few would gamble if everyone lost quickly almost all the time. Cost also is a factor. The casino needs to cover its operating costs, and this cost sets the equilibrium margin in a competitive market.

It might appear at first as if a commodity market-maker could take the same approach. If the average price of gas were $2.00 over many months, and the market-maker offered gas at $2.12, on average he would make 6 percent. In reality, commodity prices are less certain than roulette tables

because the price remains uncertain even with high volumes. Further, the prices for more distant periods may be even more uncertain than nearer-term forward prices.

In commodity markets, the margin will also reflect the extent to which the market-maker considers the value to be uncertain. The way to manage the risk is not just increasing volume, but also changing a margin so that the actual resulting average price is higher than the a priori expected price. The more uncertain the future average price, everything being equal, the higher the margin. For example, if you think the average price is $20 per megawatt-hour, but the possible range is $19 to $21, the margin will be smaller (e.g., less than 1) than if the range is $12 to $28 (e.g., 4 to 8).

Each margin level has a certain risk level (higher margins, lower risk) that can be calculated. Corporate financial staff then provide a required rate of return for this risk level to ensure that the margin is not below minimum acceptable levels. t

Judah Rose is a vice president at ICF Kaiser International, Inc., Fairfax, VA. Charles Mann is a