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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

greater on the Transco Zone 6 market than on the Columbia-Appalachia market. 5

Thus, it should be important for LDCs to regularly review information on location basis and to provide this information to the regulator. If the basis remains constant over time, there is little reason for a utility to hedge this risk no matter how large the magnitude of the basis. What matters is not the size of the basis, but whether it varies over time.

Some companies tout the importance of basis trading and also the need to hedge basis risk. Often this hedging is accomplished through a basis swap. It is a very lucrative, almost risk-free business for some companies making the arrangements underlying such swaps. At the same time, the swap instrument is usually settled on a monthly (not a daily) basis and thus often provides little protection from price spikes that are often short lived.

Companies can also reduce basis risk through rights to assets such as nearby storage and firm transportation. The physical asset approach may be much better than a financial approach here. When basis risk is greatest, it is often not just price risk but it is also volume risk that is at play.

Volume Risk: Hedging Separately for Baseload and Peak

Natural gas utility customers carry significant exposure not only to price risk, but also to volume risk, or the variability in the amount of natural gas service they require. For most utilities these requirements will be largely determined by changes in temperature. (Volume risk does not include changes in requirements caused by changes in the number of customers, since the influence of new customers on overall requirements is usually well understood, small and can be readily calculated. 6)

Customers are left with a significant amount of price risk exposure if a utility hedges 10 billion cubic feet of November requirements. Yet, there is a 50 percent chance that requirements will be above 25 billion cubic feet. However, there is also a large proportion of possible requirements that will be near 25 billion cubic feet. And there might be a 10 percent chance that peak requirements would exceed 50 billion cubic feet.

The LDC might also want to hedge some portion of this last peak requirement, especially if it expects prices to increase significantly when requirements exceed 50 billion cubic feet. It might do that with a call option.

Nevertheless, not all volume risk relates to peak requirements. The utility also faces a certain probability that loads will remain at base (minimal) levels. Thus, any determination of customer exposure to volume risk requires an examination of historical data on load requirements, which must be adjusted for changes in the mix and number of customers.

For example, it might prove useful to compute the expected relative frequency (chance or probability) of different levels of requirements by month-a 1 percent chance of requirements less than 10 billion cubic feet, a 10 percent chance for requirements less than 12 billion cubic feet, a 20 percent chance for less than 14 billion cubic feet, and so