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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

selling gas has become such a major part of the business today. Yet the use of extensive market intelligence in the buying and selling of gas is not ordinary business practice for many utilities. Nor do utility employees often possess the skill to take past price behavior to put a value on operationally flexible assets.

At a minimum, before outsourcing, the utility would want to obtain cost and other information on available price risk management programs from major companies. It might also want to estimate earnings foregone by any rights it gave up as part of any outsourcing.

Certainly, it would need to clearly identify the expected services from price risk management programs and develop standards for evaluating the services provided by price risk management programs and the expected full cost of the service over time. Perhaps a consultant could help with this task.

Regulatory Supervision: How Much Oversight?

Although the commission should probably allow the company discretion in deciding when to put on a hedge, there should ordinarily be little discretion on when to close out a position unless arbitrage returns can be demonstrated. Generally the derivative position is closed at the same time the company completes the physical deal that the derivative position hedged.

Financial Accounting Standards 133 and 138 require utilities to use the current market value of the commodity underlying the derivative to determine the value of the position at regular time intervals. This step is accomplished by calculating whether closing out the derivative position at the time would yield a net gain or a net cost and, in turn, reporting these results.

Computing Volatility
Do it easily in Excel

Volatility is the standard deviation of percentage changes in price. A first step measure of volatility can be calculated easily in EXCEL by applying the command STDEV to a series of daily percentage changes in price in a column of a data file.

A staff person might use 30 days of price information for this calculation. Staff would then annualize these values by multiplying the standard deviation based on daily values by the square root of 252 where 252 is the number of trading days in a year. This estimate can be automatically updated each day as new price data is received.

Volatilities can also be calculated using high and low prices for a day. Modeling and estimating volatility should improve along with experience in effectively engaging in price and arbitrage management programs.*

Over time, one should expect to see a small net difference in value on the physical and derivatives markets at maturity of the derivative position. Any net gains or costs are expected to cancel out as a wash. In fact, showing evidence of this convergence should become a part of the regular reporting of the status of the risk management program. FASB Standards 133 and 138 require utilities to provide evidence that derivative positions will provide effective hedges, prior to the implementation of a risk management program. The reporting of such information may well indicate the risk in completing transactions prior to maturity and also