Natural Gas Hedging: A Primer for Utilities and Regulators
What LDCs should already know.
forth. The safest strategy for a utility is to hedge volumes that are clearly expected to be purchased for all months. Naturally the problem here is that consumers might still be left with an enormous amount of price risk exposure.
There are usually few easy, cheap or exact solutions to the problem of volume exposure. One strategy might involve hedging expected purchases with a futures contract but to hedge peak requirements with a call option that offers the right to buy a certain amount of gas at a fixed price. Another strategy might involve a cost-free collar for peak requirements, where the utility would receive both a floor and a ceiling price. The collar is free because the price the utility pays for the call or cap is cancelled, in effect, by the price it receives for providing a floor price for a producer or other seller of natural gas.
Whatever the strategy, the LDC must understand the statistical relationship between changes in requirements and changes in price if it intends to provide hedges for more than requirements that are clearly expected to be purchased. 7
Cash vs. Futures: The Quality of the Hedging Instrument
The relationship between changes in price at the futures market and at the cash market can be expected to change over time. Regulators and utilities alike should monitor this relationship.
If the price of the commodity on the futures market changes by a certain amount during a period of time and the price of the commodity on the cash market regularly changes by the same amount, then the LDC would enjoy a "perfect" hedge. It would open one position on the futures market for each unit of exposure to requirements service that it wanted to hedge. (A hedge ratio of one.)
Similarly, if the change in cost of the commodity on the cash market runs only half as great as on the futures market, then the LDC again would enjoy a perfect hedge. In this instance it would open one position on the futures market for each two units it wanted to hedge. (A hedge ratio of 0.5.) Small differences in price changes can be ignored, producing a "near-perfect" hedge.
By contrast, if the relationship between changes on the cash market and changes on the futures market are not near perfect, then some quantitative measure must be reported of how imperfect the relationship is. A measurement of the degree of this imperfection must be reported, because with a less-than-perfect hedge, the utility would be expected to accrue net costs or net gains at the time it closes out its futures position.
Regulators may perceive the idea of net costs or net gains as going against the grain. After all, the purpose of a hedging program is to fix costs-not to be left with unexpected gains or costs incident to the hedging program. Both the regulator and the utility will want to perform a statistical analysis to establish the degree to which these gains and costs are likely to cancel over time, and how large they are likely