1	Hedging Natural Gas Supply With Financial Instruments – A Primer for Lawyers Marty Blake The Prime Group, LLC 502-425-7882
2	Risk Management Goals Float a fixed price Fix a floating price Reduce price variability Reduce quantity variability Tie price of energy to the price of a product (ex. Aluminum or steel)
3	Variability of Customer Energy Bills Price X Quantity = Total Bill Price of energy and quantity used are frequently correlated This correlation compounds variability of total bill
4	Natural Gas Price Variability Demand Weather Gas-fired electric power production (seasonal?) Supply Availability of natural gas storage Availability of gas transmission pipeline capacity Availability of natural gas
5	1999 Daily Natural Gas Prices Chicago – LDC’s, Large End-Users ($/MCF)
6	1998 Daily Natural Gas Prices Texas Gas Zone SL ($/MCF)
7	Daily Natural Gas Prices Texas Gas Zone SL ($/MCF)
8	Natural Gas Futures Contracts An agreement to buy or sell natural gas at a certain time in the future for a certain price Contract specifies the delivery of the underlying commodity Assures that futures and cash prices will converge
9	Natural Gas Futures Contract Trading Unit: 10,000 million British Thermal Units (MMBtu) Delivery Location: Henry Hub in Louisiana Delivery Period: No earlier than 1st calendar day and no later than last calendar day of month. Deliveries as uniform as possible on an hourly and daily rate of low during the delivery month.
10	Natural Gas Futures Contract Trading Months Futures - 30 consecutive months plus a long dated 36th month Options - 12 consecutive months plus 18, 24, 30 and 36 months Last Trading Day Futures - The fifth business day prior to the first day of the delivery month Options - Expiration occurs the business day preceding the termination of the underlying futures contract
11	Natural Gas Futures Contract Price Quotation: $/MMBtu Minimum Price Fluctuation: $0.001/MMBtu Maximum Daily Price Fluctuation: $1.50/MMBtu for the first two months
12	Weather Futures Contract Size: $100 times the CME Degree Day Index CME Degree Day Index for a Month HDD Index = S Max {0,65- daily avg. temp.} CDD Index = S Max {0, daily avg. temp. - 65} Minimum Tick: 1.00 Degree day Index Point ($100)
13	Weather Futures Termination and Settlement Day: 9 AM on the first business day which is at least 2 calendar days following the last day of the contract month Settlement Price: CME Index of the contract month calculated by EarthSat
14	Weather Futures Measuring Stations Atlanta Chicago Cincinnati New York Dallas Philadelphia Portland Tucson
15	Forward Contracts An agreement to buy or sell natural gas at a certain time for a certain price Private agreements between two parties Contracts do not have to conform to the standards of a particular exchange
16	Forwards vs. Futures Private contract between two parties Not standardized Delivery usually takes place Settled at end of contract Traded on an Exchange Standardized Contract usually closed out prior to delivery Settled daily
17	Long Hedge for Natural Gas Buy futures contracts now Sell futures contracts and buy the cash commodity simultaneously at some later date Used by natural gas purchasers (utilities or customers) to protect their purchase price
18	1^st Example of Long Hedge April 15, 2001 Buy 5 January, 2002 NYMEX natural gas contracts @ $4.00/MMBtu December 15, 2001 Sell 5 January, 2002 NYMEX natural gas contracts @ $8.00/MMBtu Buy 50,000 MMBtu of natural gas for $8.00/MMBtu
19	1^st Example of Long Hedge
20	1^st Example of Long Hedge
21	2^nd Example of Long Hedge
22	2^nd Example of Long Hedge
23	2^nd Example of Long Hedge
24	Short Hedge for Energy Sell futures contracts now Buy futures contracts and sell the cash commodity simultaneously at some later date Used by natural gas producers or marketers to lock in a price for the natural gas that they expect to sell
25	1^st Example of Short Hedge
26	1^st Example of Short Hedge
27	1^st Example of Short Hedge
28	2^nd Example of Short Hedge
29	2^nd Example of Short Hedge
30	2^nd Example of Short Hedge
31	Effect of Routine Hedging Program Reduce price variability Increase average price
32	Should Utilities Hedge Natural Gas? Pro Reduces price variability for the customer Reduces customer complaints Con Increases the average price. A customer that can handle the price variability may want to benefit from the lower average price. Customers are not making their own risk management choices
33	Natural Gas Options A legally binding agreement that confers the right, but not obligation, for the holder to buy (call option) or sell (put option) a natural gas futures contract at a price agreed now (the exercise or strike price) by a specified date in the future (expiration date). This option is obtained in exchange for payment of a premium.
34	Call Option For utilities and customers (natural gas purchasers), a call option can be used to limit the upward price exposure for natural gas while retaining the ability to benefit from downward price movements Must pay the premium to obtain this benefit
35	Call Option Example Purchase a call option on April 15, 2001 with a strike price of $3.00 /MMBtu with an expiration date of December 26, 2001 for a premium of $1,000 If price goes above $3.00 /MMBtu during this period, exercise the option, buy natural gas and sell the natural gas futures
36	Call Option Example For example if natural gas goes to $4/MMBtu, exercise the option -$30,000 Sell futures contract +$40,000 Buy 10,000 MMBtu at $4/MMBtu = $40,000 Profit from futures reduces the delivers cost of gas to $30,000
37	Call Option Example If the price of natural gas is below $3/MMBtu, let the call option expire and purchase natural gas at the lower price Call options provide a form of price risk insurance against upward price movements while preserving the ability to benefit from lower natural gas prices
38	Regulatory Issues Will regulators accept hedging losses as well as hedging gains? Will there be second guessing on the price that the utility “locks in”? Are regulators aware that the likely impact of routine hedging is to increase the average price but to significantly reduce price variability?
39	Regulatory Issues Is an outcome of increasing the average price but significantly reducing price variability consistent with any legislative charge that regulators might have to assure that natural gas is provided at the lowest possible cost to customers? With a contract size of 10,000 MMBtu, how can smaller customers participate?
40	Probing Customers’ Risk Management Goals Float a fixed price Is the customer’s goal to buy all of its inputs at market? Is the utility willing to offer a market priced product? Would the customer be interested in achieving market pricing through the use of risk management tools?
41	Probing Customers’ Risk Management Goals Fix a floating price Is the customer’s goal to hit a given energy budget? When is the customer’s energy budget set? How much does the price and total bill paid by the customer vary? Which elements of the price paid by the customer vary?
42	Probing Customers’ Risk Management Goals Reduce quantity variability How much does the customer’s usage vary due to weather? How much of customer’s variation in usage is due to other factors? Is the customer interested in using weather futures to reduce the financial impact of usage variations?
43	Probing Customers’ Risk Management Goals Tie price of energy to the price of a product (ex. Aluminum or steel) What is the customers primary product? How much price and revenue variation is the customer experiencing for the product that it produces? Are there cross-hedging opportunities for the customers primary product?