Natural Gas Hedging: Benchmarking Price Protection Strategies

Background
Natural gas is the cleanest burning fossil fuel producing less emissions & pollutants than either in coal or oil It is also the next best alternative to crude oil Dependence of crude oil & growing emissions can be substituted by Natural gas which is a cheaper & cleaner fuel Energy security and fuel diversifications policies have also played an important role in encouraging gas demand as a means of reducing dependence on imported oil.

introduction
 Energy markets operate in an environment exposed to a variety of risks responsible for the high volatility of the prices of oil, natural gas, electricity and freight rates.

 The need to control this price volatility has prompted the development of valuation and risk management methods for energy assets

 Derivative contracts are incredibly powerful tools for managing expected return and risk.

 This report provides an In-depth analysis of the rationale of hedging in the natural gas market.

Objective of the Study
Finding the perspective with which risk management is done in the energy markets.

Types of derivatives instruments global markets have and their benefits to the natural gas industry.

Study of Risk matrix in Natural Gas industry.

Study of Natural Gas Contracts

Purpose of the Study
To acquaint knowledge with
  

Natural Gas Trade Natural Gas Contracts Hedging instruments

LITERATURE REVIEW
Referred :
  

Options, Futures, and other Derivatives by John.C.Hull Natural Gas Trade by Pennwell Books Energy Price Risk Management by Tom James

 Websites Referred
   

ICE International Energy Agency Platts & Argus Traders Log

NATURAL GAS CONTRACTS
History Of Natural Gas Contracts

NG Sales and Purchase Agreements (SPAs) were developed from pipeline gas contracts from early days of NG industry.

At that time, both seller and buyers needed long term commitments to provide security to raise finance, often running into billion of dollars, for their respective facilities.

The terms and conditions in NG SPAs include severe penalties for a failure to perform including, for example, obligations for the buyers to pay for an agreed volume of NG even if it is unable to take all the volume (take or pay).

TYPES OF NATURAL GAS CONTRACT
Natural Gas Contrac ts

Long Term

Short Term

Long Term Contracts
3. 4. 5. 6. Fixed price, till the contract lasts. Future estimations of demand and supply done. Less risk. With limited it volume supports of the flexibility, business.

Short Contracts
3. More flexible contracts

Term

4. Made on the basis of a single – cargo or a number of cargoes over a limited period of time 5. The price will either be fixed when cargo is loaded or it may be linked to an escalator 6. Risk of volatility and high prices

development of the natural gas

Risk Management
 

Every business has Risk-Return tradeoff at its heart. An opportunity to earn handsome returns comes with a risk of heavy losses.

The Energy Industry and its associated markets experience a lot of risk due to the volatility involved.

The businesses must learn to assess and manage this risk in ways that allow them to exploit opportunities while limiting their exposure to unpredictable factors in their operating environment.

THE RISK MANAGEMENT PROCESS
  

A comprehensive risk measurement approach A detailed structure of derivative position limits Clear guidelines and other parameters used to govern risk taken by officers of the organization

There should be a strong risk management information system for
 Controlling Risk  Monitoring Risk  Reporting Risk

Risk Matrix in Natural Gas Industry

HEDGING
Hedging is a powerful financial tool. It can be used a strategy to enhance or insure against investments.

Hedging is a risk mitigating activity

Taking a position in futures market that is opposite to a position in the physical market.

Why hedging?
Financial and Commodity Derivatives are Financial instruments that have been traded in Global Markets for past 100 years
Hedging: Risk reducing strategies with aim to limit losses
or lock-in profits in bear and bull markets respectively

Speculation: Leveraged investments bearing
unlimited profits or losses.

Hedging Principles Checklist
What Factors Affect a Hedging Strategy?
Is there a Profit or Position to Protect?  Specific position to protection or general portfolio insurance?  Locking-in current levels or protecting against tail risk?

Are There Specific Risks to Protect Against?  Risks that market drifts lower or Gaps lower?  Macro inflection points: interest rates, FX.  Geo-political event risk

HEDGING INSTUMENTS
Hedging instruments include
Interest Rate Risk Interest Rate Swaps Interest Rate Futures Equity Options Equity Swaps

Equity Risk

Credit Risk

Credit Default Swaps Credit Options

Commodity Risk

Commodity Swaps Commodity Futures Commodity Options

Currency Risk

FX Futures FX Options

HEDGING STRATEGIES

Forwards

Forward contracts are based on physical delivery of the underlying commodity during an agreed time period in the future, either a full calendar month or a specified part of it.

They specify standard quantities and qualities, and are subject to a mutually agreed set of terms and conditions in order to provide a flexible trading instrument

Forward contracts involve a number of delivery risks for the parties concerned that do not arise in the case of futures contracts.

Counter party default risk

futures

It is an agreement between two parties, a buyer and seller, for delivery of a particular quality and quantity of a commodity at a specified time, place and price.

Uniqueness of these contract is that 98% of the positions are squared off before expiry

These contracts are suitably preferred for risk mitigating activity.

Options

Give the option holder the right, but not the obligation, to buy (or sell) an underlying asset at a specified price during an agreed period of time.

Two basic types of option contract
 

Call/Cap options, which give the holder the right to buy; Put/Floor options, which give the holder the right to sell.

An options contract will only be exercised if the market moves in favor of the holder.

OPTION COMBINATION STRATEGIES

Option spreads involve taking simultaneous opposing positions at different exercise prices or strike prices.

Straddles involve selling call (cap) and selling put (floor) at the same strike price in the same market.

Vertical Spread involve Selling (or buying) a lower priced put (or call) option while buying (or selling) a higher priced one is bullish; taken in reverse, the vertical will be bearish.

Butterfly strategy is a more complex options spread built from options bought and sold at three different strike prices.

 

Say if the natural gas contract is trading at $4, A long butterfly could be made by buying puts (or calls) at $3.8 and $4.2 and

 

Selling twice as many puts (or calls) at $4. The maximum profit comes if the contract is right at $4 at expiration, and

The maximum loss occurs if the price moves past either $3.8 or $4.2.

Swaps

A swap is a purely financial transaction that is designed to transfer price risk.

A swap can be most simply defined as an agreement between two parties to exchange, at some future point, one product, either physical or financial, for another.

But, in derivative form swap is purely cash settled.

The attraction of swaps is three‐ fold.

First, they are purely financial transactions and can therefore be traded without incurring the quality risks and other delivery problems normally associated with physical oil contracts.

Secondly, they offer the prospect of the “perfect hedge” since they can be tailored exactly to meet the requirements of each participant.

And, thirdly, and most importantly, they can be traded far into the future since they are not constrained by the more limited time‐horizons of existing futures or forward markets.

ENERGY SPREADS
Spark Spreads

The spark spread involves the simultaneous purchase and sale of electricity and natural gas futures contracts.

This allows traders to take advantage of the generic conversions of natural gas to power to help price the forward electric power curve using natural gas-fired generation operating efficiencies and prices.

 By

buying natural gas futures at a relatively low price and

selling electricity futures at a relatively high price, generator is hedging his profit margin for physical sale.

Conclusion

Price risk management tools such as derivative instruments are used to manage price volatility in order to protect company revenues and profits

The hedger uses derivatives to protect a physical position or other financial exposure in the market from adverse price moves which would reduce the value of the position.

The hedge position is established to buffer against day-today market fluctuations in accordance with strategic company objectives.

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