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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

hedging program, the size of the opportunity and administrative costs associated with overpayment by consumers and under-collection for gas service provided by the utility could get reduced significantly. Administrative costs decline if bills need to be adjusted less frequently. Opportunity costs decline if the amount of under-collection by companies gets reduced. Each dollar of avoided under-collection or over payment by consumers should yield the market rate of return on money.

A utility might also consider locking in a cost for forward delivery so as to avoid a higher cost of forward delivery from conventional storage-as long as that does not increase exposure to volume risk. It could also sell some gas out of storage when the spot price greatly exceeded the commodity cost and the full cost of storage.

Especially high spot prices are often associated with what is termed a convenience yield. Convenience yields occur because some buyers at particular times are willing to pay a very high price for additional gas to cover requirements. Thus, those that have the gas readily and conveniently available capture the convenience yield. The changes in price associated with these yields are considered separable from ordinary price volatility and the exact time when they are likely to appear is, of course, unknown and the price level associated with these changes are not expected to persist. The information in Figure 6 is useful for calculating estimates of convenience yields.

Program Administration: To Outsource or Not?

Many major energy companies are very interested in providing risk management services to utilities. They might couple such service with an offer also to perform gas acquisition and to manage utility assets. These companies have considerable expertise in these areas. To the utility it might seem natural to outsource these functions.

Nevertheless, by hiring an outside firm for risk management and related services, the utility might also end up forgoing the use of historical customer usage information that could prove of great value in designing such programs. 14 It could provide such information to the outside firm, but it may be prevented from doing so because of practical or legal reasons.

It would also forgo the collection of customer data-the very information that would otherwise enable the utility to fashion a risk management program crafted to the risk preferences of its customers. Generally, neither the outside risk management firm nor the utility has this expertise.

The utility would also lose opportunities to capture arbitrage returns. Those opportunities would pass to the outside firm-a good reason why it might want to take over risk management in the first place.

Some companies providing risk management services are major buyers and sellers of natural gas and power. They have the capability of both developing and selling derivative instruments and using existing derivative markets. In fact, the utility might well stand as a handy counterparty to complete an arrangement for one of these derivative instruments-and the utility would end up paying a fee for the privilege.

Instead, the utility might well view risk management as a core competency that it must develop, because buying and