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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

gas markets. 3 Price volatility ran higher in summer 2000 than in summer 1999 because storage operators found themselves competing increasingly with natural gas power generation operators for scarce supplies of gas-even as tremendous uncertainty prevailed over availability of supply.

Regulators might do well to require LDCs to file regular quarterly reports of price volatility measurements. Such reporting would include both the formula used to compute price volatility and also standard ways of reporting this information in tables and figures ().

Standards have yet to be established for reporting this information. Eventually, however, estimates of price volatility and expected bounds for such estimates should become as commonplace and as well understood for regulators as rates of return on capital. Information to report might be annual and seasonal norms, expected deviations from seasonal and annual norms and also expected future volatility. In many instances, it would be assumed that the current level and pattern of volatility would continue into the future.

Basis Risk: Price Behavior May Affect Value of Storage

Utilities purchasing gas directly in consuming markets may be exposed to a separate price risk, in addition to the commodity price risk associated with market behavior at the Henry Hub, or indeed at other market hubs in upstream, producing areas. This added risk complicates hedging programs. Yet there is good news, too. The stronger the correlation between changes in price between consuming area markets and the Henry Hub, the less need there will be to use hedging instruments beyond the Henry Hub futures and options contract. 4

The price risk from engaging in local markets is usually referred to as basis risk or more precisely, location basis risk. Every working day the natural gas trade press reports on the basis differentials for a variety of locations. These bases simply mark the difference between the average daily spot prices at a pair of locations, such as Chicago and Henry Hub. Location basis risk stems from the variability of these price differences.

At one time, many expected that basis differentials would remain constant, reflecting the cost of transportation between any two points. Instead, basis and basis price volatility is now observed to vary over time and also by region. Most often the magnitude of the basis appears to bear little relationship to the cost of transportation (or at least to the cost of firm transportation).

Consider the example of the location basis between the Henry Hub and Columbia-Appalachia (). The value of the basis generally is less than the cost of transporting the gas from Henry Hub to the Columbia-Appalachia market. This fact suggests that an LDC in the Northeast U.S. might consider purchasing more natural gas from the Columbia natural gas market and less natural gas from the Henry Hub and nearby markets.

The basis for Columbia-Appalachia from Henry Hub is also, interestingly enough, much smaller and less volatile than for the nearby Transco Zone 6 market. Price spikes also tend to run much higher on the Transco-Zone 6 market. That fact suggests that the value of accessible and operationally flexible storage is much