Hedging Natural Gas Price Risk

presentation to

APPA 2004 Joint Action Workshop

Dec. 5-7, 2004

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Hedging Natural Gas Price Risk

Why risk manage?

FMPA’s situation

Hedge products pros and cons

Product mix

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Why Risk Manage?

The electric generation business has many inherent risks

Some of these risks bear significant financial impacts

Develop a program to “manage” or mitigate these risks

Avoid bad outcomes

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FMPA’s Precipitating Event

NYMEX Natural Gas - Henry Hub

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

1/4/2000 4/4/2000 7/4/2000 10/4/2000 1/4/2001 4/4/2001 7/4/2001

$/m

mB

tu

Prompt Month Settlement

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Other Precipitating Events

Catastrophic failure of generation

Fuel supplier insolvency

Loss of transmission or fuel transportation

Non-performance under long-term commitment

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FMPA’s Response

Identified major risk – i.e. natural gas prices

Educated staff

Hired expertise, staff or consulting

Drafted energy risk management policy

Started slowly

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Natural Gas Price Risks

Some entities may have a fixed price for natural gas imbedded in their rate structure

Others may be exposed to market based prices

Two different approaches

FMPA falls into the former category

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How Much to Hedge?

Varies depending on risk appetite

FMPA started with a: 33% fixed price, 33% first-of-month index

price, 33% daily spot price mixture

Determined that this didn’t provide enough protection

Moved to more fixed price protection

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How Long to Hedge?

FMPA began with hedging the near-term period – roughly 6 months to 1 year

Empirical evidence that showed a 24-36 month hedge profile showed greater success

FMPA moved to a longer-term program

Hedge % more heavily weighted toward near-term

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Hedge Products

Products vary depending on price exposure

NYMEX Futures

Good liquidity for one year to eighteen months

Recognized standard for natural gas market

Works best for fixed price exposure

Margin requirements can be burdensome of cash flow

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Hedge Products Continued

Swaps

Good liquidity for 1-6 years

Requires ISDA agreements with multiple parties

Depending on credit, may or may not require margining

Premium to NYMEX for added liquidity

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Hedge Products Continued

Options

Calls - upside protection while allowing for downside participation

Puts – downside protection of fixed price hedges

Depending on market volatility, can be “expensive” protection

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Hedge Products Continued

Collars

Combination of calls and puts

Sale of puts buys down cost of call

Spreads

Purchase a call, sell a higher strike price call

If market moves above higher strike, have spread advantage over market

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Hedge Products Continued

Fixed price physical purchases

Good liquidity for 1-3 years

If load doesn’t materialize, must sell into market

Contracts with multiple counterparties

Credit becomes a concern

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Hedge Products Continued

Basis Swaps

Good protection for market price exposure

Minimizes exposure to regionalized market swings

Doesn’t protect commodity exposure

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What Products to Use?

Experimentation with a variety of products

Over time optimal mix will become evident

FMPA started with fixed price physical and futures

Current program has mixture of many product

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How Much Does It Cost?

Hire some expertise, staff or consultant

Exchange broker fees are minimal

Option premiums can add up but can help avoid embarrassing outcomes

FMPA has allocated $2 million/year

Costs have run less than half of this

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Final Comments

Determine where your exposures lie

Start slowly and educate staff and board

Hire expertise

Find the optimal product mix

Set expenditure limits and stay within them

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Hedging Natural Gas Price Risk

Questions?