Developing a natural gas hedging process

Jay Lindgren and John Wengler, R. W. Beck Inc.

Many utilities are currently trying to develop a hedging program for their natural gas needs. This task consists of determining utility’s natural gas needs and risk with respect to market price, with a comparison to the organization’s risk tolerance.


Jay Lindgren
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This task involves developing a stochastic (random) model of the financial and physical behavior of the utilities system and portfolio. This model includes such things as the variability in the price of power and fuel and variation in load. The results risks are compared against the utilities risk tolerance. The utility’s risk tolerance determines the appropriate amount of risk to leave in the portfolio and how much must be hedged away.


John Wengler
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This valuation and risk analysis is often based on the assumption of asset options and market inputs at the time of the study. The valuation of mark-to-market optionality will change based on changes in market conditions or changes in model assumptions. It is worth noting that developing risk-management related programs such as hedging is a continuous process. So when developing a hedging program for the first time, the utility should keep an eye toward creating processes that can be repeated with relative ease.

Methodology

In order to perform this analysis, utilities utilize the full compliment of risk management and analytical tools to both build and evaluate their portfolio. Many utilities have developed a framework that includes the following interrelated elements:

“- Forward price curves, which include the risk-adjusted expectations of spot prices across future time;
“- Volatilities, which are the expected variations in the forward prices;
“- Correlations, which characterize the relationships between variables such as prices and volume of various power and energy markets;
“- Contract valuation models, which value fixed- and variable-rate contracts as a function of today’s expectations of forward prices, volatility, and correlations;
“- Risk measurements, which assess the probable impact on the portfolio value given potential changes in the market.

To provide a framework for this analysis the utility will often use an off-the-shelf software package. There are also many shops that build their own systems. Additional analysis is often done outside of the off the shelf systems in models developed specifically for utility.

Once the valuation and risk analysis framework is in place, the utility should identify alternative hedging programs which consist of different types of contracts that hedge different aspects of risk. For example, one hedging alternative program could have fixed-price forward contracts whereas another could be comprised of options.

Some utilities utilize a process in which alternative hedging programs are added to the target portfolio. The resulting “hedged portfolios” are then evaluated to determine the “before and after” effectiveness in hedging the natural gas exposure. If this process is repeated for each hedging alternative, the organization can develop a sense of what works and how.

Another important benchmarking process is to test the alternative hedging programs under different price scenarios. This evaluation process begins during the initial valuation using the current natural gas forward price curve (also referred to as the “base case”). Then, “stress test scenarios” are created in which the natural gas forward price curve is shifted by fixed dollar amounts. For example, four scenarios could be explored with shifts of one dollar, two dollars, five dollars and minus one dollar. Each hedging alternative is then revalued and analyzed for each of the stress test scenarios.

Alternative hedging programs

Hedging can be performed with a variety of available positions, but, generally speaking, the choices may be reduced to using either forwards or options (or a combination of the two types of contracts).

Forward contracts are fixed-price positions that do not require upfront payment at the time of contracting. Payments occur at the end of the expiration and settlement periods. In energy markets, physically settled contracts involve both the physical delivery of the commodity following by the payment. Forward contracts oblige both counterparties to these payments and deliveries.

Option contracts are known as “contingent liabilities” because the option buyer has the right but not the obligation to execute the option at the time of expiration. (If the option is executed by the option buyer, both the option buyer and option seller are then obligated to fulfill their contractual obligations.) Another difference with forwards is that options involve payment of an upfront premium. The price of premiums is a function of the option strike price–where the strike is the price at which the underlying asset is purchased (or sold) when the option is executed. For a call option in which the buyer has the right to purchase the underlying asset, for example, the premium increases as the strike price decreases. This relationship is analogous to home insurance where premiums increase as the deductible decreases. For a put option in which the buyer has the right to sell the underlying to the option seller, the premium increases as the strike price increases.

Forward price contracts are generally considered more conservative since they lock in the organization’s obligations. They tend to perform very well at hedging small price movements but can be frustrating if large price movements in the “wrong direction” leave the hedger “stuck” with paying “too much” or selling for “too little”. (See the organization’s who purchased high-price power during the height of the California Crisis only to see spot prices drop dramatically.)

Options, on the other hand, require a more aggressive upfront commitment of premiums; options also simply sound scarier. Options are generally used to hedge larger price movements. Unlike forwards, options are simply that–options. The option holder always maintains the prerogative to execute on the contract or not.

Analysis of hedging effectiveness

If the organization has a clear idea of its hedging objectives, the hedging analysis provides the numbers and comparisons with which to pick and choose the optimal hedging programs.

If price stability is key, for example, then the “best” hedging program is that which either locks in prices or reduces volatility. If the organization has multiple or hybrid objectives, the hedging analysis should at least provide a framework in which alternatives may be judged.

What if the organization does not already have firm objectives? The hedging analysis could be used as the talking point for crystallizing such objectives. There is nothing like a good “stress test” to grab management’s attention and force them to articulate what they want and do not want. Like a Rorschach Test in psychology, showing management pictures of hedging results can evoke an emotional response that speaks volumes to fears and hopes for the organization’s future.

Hedging analysis is ideally updated prior to any hedging activity and reviewed and updated periodically to account for changing conditions, particularly with regard to load growth; technological advancements in generating equipment; changes in environmental laws and other regulatory considerations; changes in fuel and power markets and new financial instruments. Decisions are usually made by basing its conclusions and recommendations on information provided by the market and models that reflect its portfolio and positions exposed to market conditions at the time of the study. As these conditions change, the applicability of conclusions and recommendations may require reconsideration.

As head quantitative specialist in R. W. Beck’s energy risk management practice, Dr. Lindgren develops and implements advanced quantitative methods within R. W. Beck and at client organizations relating to asset/contract valuation, risk and portfolio optimization. He can be reached at jlindgren@rwbeck.com.

Wengler, an executive consultant with R.W. Beck, is a risk management educator and the author of “Managing Energy Risk: A Nontechnical Guide to Markets and Trading” (PennWell, 2001). He can be contacted at jwengler@rwbeck.com.

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