[BETA] Fortnightly

Natural Gas Hedging: A Primer for Utilities and Regulators

 

What commissions need to learn.
What LDCs should already know.

The facts are now in. If utilities had hedged their natural gas purchases during the 1990s , they could have earned windfalls for those they serve, given the wild price gyrations of the past decade (). Yet few if any households or businesses saw any windfall, because few utilities were engaged in futures and other derivatives markets.

All the same, any windfall gains for utilities that hedge are perhaps best viewed as a matter of luck. Many (including regulators) will still see the derivatives markets as protection from ordinary ups and downs in price-not as a source of profit.

And so one can easily understand why utilities have shown a marked reluctance to embrace derivatives markets. Without adequate controls, utility companies (by design or ignorance) might end up transforming their hedging programs into trading programs. Remember also that commodity volumes can carry huge risks. Thus the possible losses from a derelict hedging program are huge. It is not unknown to hear of a hedging program that derailed into disaster.

Some utilities with excellent credit ratings, high rates of return and regular large cash flows didn't need to hedge during much of the last decade. They could offer their customers fixed bills without using the derivatives markets. ¹ But even this strategy harbors hidden costs. Utilities choosing this path still proved unable to protect their customers from the large shift in prices that occurred in 2000.

Transaction costs might also have deterred some utilities from hedging during the 1990s. Yet any good, effective and active program for price risk management may also offer opportunities for arbitrage returns that can help offset program costs. Such returns, when combined with the avoided cost of defending a prudence review of gas purchase costs, and other benefits pointed out here ought surely to outweigh the cost of a hedging program.

The question of who pays for the hedging program is also a bit sticky. Yet if consumers want bill stability, as they seem to, then they should pay for the ordinary cost of the hedging program. There is nothing new here. The consumer already pays for the other types of insurance that the gas distribution utility typically provides, such as reliability of service, made possible by firm transportation and storage. Moreover, when retail markets become fully competitive, then cost will become less of an issue. If consumers want price risk insurance, then the retailer offering the best package will win the day. Of course, providing such insurance continues to be more difficult in the energy industry than for other types of businesses. In retail energy, where temperature largely drives consumer behavior, the uncertainty extends not only to price, but also to volume-a key difference from other retail businesses.

Nevertheless, the science of risk management is well understood, if not the art. Then what will it take to bring utilities and commissioners on board?

Perhaps the key lies in making regulators more comfortable-in drawing a blueprint for regulators