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Natural Gas Hedging: A Primer for Utilities and Regulators

What commissions need to learn.
What LDCs should already know.
Fortnightly Magazine - October 1 2001

on how to regulate a hedging program. Here is a start, a rough outline of at least five objective measures that a state utility regulator might want to monitor in a world where natural gas local distribution companies (LDCs) become engaged in risk management and trading in derivatives:

  1. Price Volatility. Historical, current and expected.
  2. Basis Differential. Between wholesale market hubs and consuming areas.
  3. Quality of Hedge. The statistical relationship between cash spot market prices and futures market prices.
  4. Requirements to Hedge. The amount of future customer requirements that can be effectively hedged.
  5. Consumer Preference. Survey and report results on what retail consumers might want in the nature of a cap on price, and what they might be willing to pay for it.
  6. Marking the Market. Determine market price of the commodity being hedged and then compare this price with the price (cost) under the hedging instrument.

Commodity Risk: Understanding Price Volatility

Volatility is the variability in price that is expected most of the time. It marks the key to assessing the value of derivative instruments. Information on volatility should make up a part of regular reports furnished to utility regulators if LDCs engage in natural gas hedging.

Volatility is usually expressed in percentage terms. Volatility of 10 percent for a given month indicates that percentage changes in prices are very likely to run 10 percent higher or lower for that month. An LDC that regularly purchases natural gas on the cash market would have this amount of price risk. The longer the time period, the greater the volatility. Thus, annualized volatilities would be much larger than monthly volatilities, as they represent the expected variability in percentage price changes over a year. Price volatility has varied by market and over time in the past. This fact suggests taking care in evaluating the value and need for derivative instruments, since their value is much dependent on estimates of volatility.

Price volatility was particularly high during January and February 1994 and 2001, and during November and December 1996, 1998, and 2000. High price volatility in 1994, 1996, and 2000 was caused by a combination of low temperatures and low storage levels. Price volatility also tends to run higher in particular markets at particular times, such as in the San Juan Basin, a producing market that provides natural gas to California ().

Such high volatility as occurred at the San Juan Basin in 2001 often stems from one or more of several circumstances. Such circumstances may include: (1) constraints in moving natural gas on nearby pipe systems, (2) sustained sudden shifts in demand and supply, (3) a lack of crucial information on the amount of physical space available on a pipe to move more gas, and (4) scheduling problems. Of course, gaming can also support price volatility-especially when individuals and groups have superior access to crucial market information. 2

Although price volatility is usually greater in the winter than in the summer, the summer season in year 2000 exhibited high average price volatilities relative to the Henry Hub market for five of nine major spot natural