Natural Gas Hedging for End-UsersNatural Gas Hedging for End-UsersManaging Your Exposure to Volatile Natural Gas Prices
Natural Gas Hedging for End-Users2In energy intensive industries, volatile natural gas prices can wreak havoc on the bottom line,not to mention the headaches incurred by management and shareholders.Volatile natural gas prices can, and often do, have a significant impact on the bottom line. Ifthese volatile costs aren’t actively managed, they can lead a company to exceed budgetforecasts, or worse, lower or non-existent profit margins.Although there are many factors that affect natural gas prices, weather, natural gas storageinventories, and economics conditions, as well as the market’s perception of these factors, arethe primary factors that drive natural gas prices.Most large natural gas end-users can mitigate their exposure to volatile and potentially risingnatural gas costs, as well as diesel fuel and electricity costs, through hedging. Hedging allowsmarket participants, such as aggregate producers which consume large quantities of natural gasand other energy commodities, to lock in prices and margins in advance, while reducing thepotential impact of volatile and rising natural gas prices.The primary reason that many large, natural gas-consumingcompanies hedge their natural gas costs is that thefluctuating price of gas can present large financial risks thathave a significant impact on the bottom line. Another reasonfor hedging a company’s exposure to natural gas price risk isto improve or maintain the competitiveness of the firm. Veryfew companies are not subject to competition; they compete with other domestic companies intheir sector as well as with companies located in other countries that produce similar goods forsale in the global marketplace. As a result, by having the ability to know and/or manage theirfuture natural gas costs, many companies can establish a competitive advantage in theirmarket.Most natural gas consumerscan mitigate their exposureto volatile natural gas pricesthrough hedging.
Natural Gas Hedging for End-UsersShifting the RiskHedging reduces exposure to price risk by shifting that risk to those with opposite risk profilesor to investors who are willing to accept the risk in exchange for an opportunity to profit.Natural gas hedging involves establishing a position in a financial instrument that is equal andopposite to the company’s exposure in the physical natural gas market; the physical market isthe “market” where a company procures the actual natural gas that it consumes in its day-to-day operations.Hedging works because the cash prices and financial prices of natural gas tend to have a strongcorrelation. Even though the difference between the cash and financial prices may increase ordecrease, the risk of an adverse change in this relationship is generally much less than the riskof not hedging.It is extremely important to remember that the purpose of hedging natural gas is to mitigatethe company’s exposure to natural gas prices, thus stabilizing the company’s natural gas costs.Hedging is not a means for a natural gas consuming company to gamble on the price of naturalgas. Gambling on natural gas prices, also known as speculating, all too often produces worseresults than doing nothing at all. Large gas consumers should use hedging to reduce theprobability that the company will be negatively affected by volatile or rising natural gas prices.On the other hand, speculators are of the opposite mentality. Speculators bet on the directionof natural gas prices in hopes that they will be able to “buy low and sell high.”Having said that, it is equally important to acknowledge the fact that if a company is nothedging its natural gas costs, it is effectively saying one of two things:1. The company has the ability to pass on any and all increases in natural gas prices to itscustomers, without a negative impact on its profit margins; or2. It is confident that natural gas prices are going to decline, and it is comfortable paying ahigher price for natural gas, if in fact its analysis proves to be incorrect.
Natural Gas Hedging for End-UsersThe primary instruments used to hedge natural gas are swaps, futures, and options. Naturalgas futures contracts are firm commitments to make or accept delivery of a specified quantityand quality of a natural gas during a specific month in the future at a price agreed upon at thetime the commitment is made. In the United States, natural gas futures are traded on the NewYork Mercantile Exchange (NYMEX).Natural gas swaps are contracts in which two parties agree to exchange periodic payments fornatural gas. In the most common type of natural gas swap, one party agrees to pay a fixedprice for natural gas on specific dates to a counterparty who, in turn, agrees to pay a floatingprice for natural gas that references a published price, such as the NYMEX natural gas futures.A natural gas option contract is a contract that gives the holder the right, but not the obligation,to buy or sell a specified amount of natural gas (or a natural gas swap or futures contract) at aspecified price within a specified time in exchange for paying an upfront premium. Breakingdown the options even further, there are call options and put options. A natural gas call optionis a contract that gives the holder the right, but not the obligation, to buy natural gas at a setprice (the strike price) on a given date. A natural gas put option is a contract that gives theholder the right, but not the obligation, to sell natural gas at a set price (the strike price) on agiven date.Hedging in ActionThe following provides a simple example of how an aggregate company can use a natural gascall option to avoid an increase in natural gas costs while allowing you to obtain lower pricednatural gas should prices decline. Assume that on June 1, you anticipate that your natural gasdemand for January will be 10,000 MMBTU (million British thermal units) and you want toensure that your cost will not rise above the current market price for natural gas to be deliveredduring the month of January. As such, you decide to buy a call option on $4.50 January naturalgas for $0.50. The current price for spot (cash) natural gas may be lower or higher than $4.50,but that is immaterial because you aren’t contracting for spot gas, you are buying an option ona contract for January natural gas. On Dec. 24 (the last day of trading before the option