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Gas Price Prudence: From Hedge-and-Hope to Best Practice

Utilities and regulators should follow the same ideas that govern risk management at the largest of commodity trading houses.
Fortnightly Magazine - October 1 2001
  • criteria, and it is the utility's burden to prove it is taking all reasonable actions to minimize its purchased gas costs. (.)
  • The New Jersey BPU instructed LDCs to submit the details of their hedging practices by November 2001 to see where they should go in the future. Only one LDC in New Jersey undertook any significant hedging activity for the winter 2000-2001.

There are common threads to all of these stories. One of the most significant, however, is this: In all cases, commissions and staff have chosen to leave undefined the standards by which LDC portfolio risk management will be judged. Is it to be a market test? A best practices test? By whose standards? Some state commissions have resorted to something akin to the old judicial standard for pornography: "I can't tell you what a bad hedge is, but I'll know it when I see it."

The heightened concern over increasing price volatility, reflected in PUC and LDC hedging initiatives, is reflected as well in the NYMEX futures and options markets in the form of implied volatility. Implied volatility is defined as the market's perception of forward volatility in the futures market. It is derived by reversing the analytical steps in any traditional options pricing model, using observed options market quotations as input data. When implied volatility is applied to a strip of futures quotes, using a Monte Carlo simulation, one can derive a distribution of probable outcomes for the given strip. The wider the distribution, the greater the expected volatility based on market behavior.

Compare the two distributions in Figure 3. On the left is the price distribution in April 1998 for all forward months. The mean price is $2.30/MMBtu, with a 22-cent standard deviation (capturing 67 percent of the area under the curve). Ninety percent of the distribution falls within a band from $1.93 to $2.70, and the full range of values falls between $1.68 and $3.34. Now refer to the graph on the right, a snapshot of the price distribution in June 2001 for all forward months. The mean price is higher, of course, at $4.11/MMBtu, but what is startling is the shape of the distribution. One standard deviation has swelled from 22 cents to $2.61, the 90th percentile covers a span from $1.31 to $9.09 and one finds extreme outliers at $0.48 and $22.37 versus $1.68 and $3.34 in April 1998.

The market can and will be wrong, but such a pronounced jump in this reasonable measure of price volatility expectations (indirectly reflecting the level of uncertainty associated with current futures prices) should certainly put all risk-averse LDCs and their state commissions on notice that price risk management practices deserve revisiting.

Getting back to our introductory anecdote, the Foster Report is quick to deliver the answer to "compared to what," at least from the perspective of Dominion East Ohio Gas (EOG). "On June 29, [EOG] filed...a gas cost recovery (GCR) proposal that will save its sales customers about 29 percent of (emphasis added) and will freeze the new rate through 4/29/02." The article goes on to