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Hedging Under Scrutiny

Planning ahead in a low-cost gas market.

Fortnightly Magazine - February 2012

all parties on avoided cost analysis. In several instances, success—or lack thereof—has been measured by comparing the hedged prices to spot market prices. The costs have included net premiums paid for call options, as well as the difference between the fixed price or option strike price and the spot market price. There is often a failure to see the cost of options as an insurance premium, as well as to consider a fixed price as a rate stabilization tool. Further, what’s missing is more analysis of the potential avoided cost. Additional scenario analysis would demonstrate the risk of what could have occurred as well as estimate the potential price exposures avoided as a result of hedging.

Additionally, some stakeholders raise the concept of “least cost” in hedging program critiques. Care must be exercised when applying the least-cost principle to hedging, which presents trade-offs in risk, reward, and costs, depending upon the hedging instrument. Using the analogy of insurance, it is possible to buy an inexpensive policy with a low premium, but this is usually accomplished by increasing the deductible, placing a cap on the total payout, or carving out conditions under which benefits aren’t paid. Additionally, different hedging strategies yield different benefits, depending on market price direction. For example, if a utility is purchasing energy in a rising-price market, a fixed price purchase might be optimal as there is no option payment incurred and the coverage starts immediately. In a range-bound market, a costless collar might be the lowest cost of insurance, and in a declining market, a cap at a relatively high strike might be the most attractive form of hedge protection.

The Shale Gas Factor

A review of comments filed by commission staff and other stakeholders shows that shale gas development is repeatedly referred to as a “game changing” technology. Shale gas producers access prolific geological deposits of reserves for production at relatively low costs, which has led to significantly dampened price volatility and lower market prices.

While the emergence of shale gas production is generally well-known by intervenors and regulators, the broader market dynamics are less well understood. Equally important is the fact that new pipeline infrastructure has served to deliver shale gas supplies into what historically have been transportation-constrained end markets, thereby changing traditional basis-pricing relationships and further easing price volatility. Additionally, new LNG import facilities and expansions in natural gas storage capacity in recent years have contributed to expanded supply capacity. These supply and capacity additions have occurred at the same time that demand has declined. On the demand side, increasing energy efficiency measures and declining demand resulting from weak economic conditions have dampened consumption.

However, history repeatedly has shown that commodity market conditions are never stagnant, and that markets often correct as supply and demand factors re-balance. The recent 24 months of price declines have lulled many stakeholders into believing that low gas prices are now the norm, but market conditions will change at some point. The question is when, how quickly, and to what degree? If we have learned anything from the past, it is