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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

to be at any time.

To address the issue of imperfect hedges and non-convergence the utility would report on a regular basis statistical summaries of the relationship between changes in cash prices and changes in futures prices. 8 The futures price used for this evaluation would most likely be the prompt month or nearby month contract; i.e., the contract next to expire on the futures market.

For reporting purposes, it is best for the utility to produce easily understood graphs rather than just statistical reports. These figures could be used to reveal the expected quality of hedges and to illustrate how many futures positions to establish for hedging a certain amount of expected purchases on the wholesale cash market.

A type of accessible graph is displayed as Figure 4. In the figure, a point on the graph indicates changes in price on a day from two markets. If the scatter of points seems to fall in a line, it will indicate that the quality of the hedge from using the futures market to manage price risk in a market such as Chicago is probably very good.

Note that the Financial Accounting Standards Board (FASB) requires the utility company (under FAS 133 & 138) to compare changes in the price of the commodity and changes in the price of the hedging instrument, and to record differences in these price changes before the institution of a hedging program. If the magnitudes for the changes are very similar than the company is provided an effective hedge. A useful way to summarize such changes, of course, is through a regression analysis.

A summary equation could be included in the body of a figure to show the relationship between the two prices. Shown in the figure is a one-to-one relationship (a line with a slope of 45 degrees, cutting the first quadrant in half). In addition, it can be pointed out that each $0.66/MMBtu ($0.10/MMBtu) change in the Henry Hub price is associated with a $0.66/MMBtu ($0.10/MMBtu) change in the Chicago price, and so forth.

Reporting of the relationship in the figure also includes some indication of the size of the error or the gain or cost to expect when a position is closed out.

For the estimated equation the expected size of the 'gain' (+) or 'cost' (-) is equal to $0.025. Further examination of the price information in the figure reveals that there are a large number of price changes greater than $0.25. Thus, the error might be considered small relative to the ordinary size of the price changes. 9 The important point the company needs to establish is whether the differences are small when the company tends to complete the physical and financial transactions.

The price information in Figure 5 extends the information in Figure 4 by including later dates. Examination reveals that several price changes are some distance from the line. These points represent prices in December and represent days on which there was a breakdown in the relationship between these markets. The figure could also be used to reveal that there were