Part 2: Energy Mid-Office Functions & Risk Management
In this article, we will focus on some fundamental elements of natural gas price risk management. These tasks are typically taken on by employees of what is termed the Middle Office or Mid-Office. Due to many factors, gas prices can increase and decrease very quickly over the short term (volatility) and can move in one direction or another over the long term. Companies who have an ongoing need to purchase natural gas for heating, power production, or chemical synthesis are exposed to this uncertainty, and financial and other products are available to manage this exposure. This blog is not a comprehensive analysis but an overview of typical concepts and terms one may encounter in this area.Companies who have an ongoing need to purchase natural gas for heating, power production, or chemical synthesis are exposed to this uncertainty, and financial and other products are available to manage this exposure. Click To Tweet
Movement in Natural Gas Prices
Actual natural gas consumption for most sectors of the economy has been relatively steady and predictable for many years. However, as the graphic below shows, residential and commercial usage is seasonal and predominately used for heating. Industrial use is also somewhat seasonal as well. It’s also interesting to note moderate declines in industrial use from 2004-2010 when gas prices were high, then increases from 2011-2020 after the shale boom.
Let’s overlay electricity use for power generation. Here, it’s clear that the seasonal pattern is opposite the residential and commercial sectors since electric power demand peaks in the summer to support air conditioning. Another observation is the steady increase in use across the entire time frame.
Several factors account for this increase. First, many new gas-burning combined cycle power plants were built and placed in service in the late 1990s and early 2000s, at the same time that the installation of wind energy was increasing in many markets. Natural gas power’s ability to quickly ramp up and down is an ideal match for the intermittent nature of wind energy production.
Second, across the US, many coal-fired power plants were retired or otherwise taken offline. Natural gas power production stepped in to fill this gap.
Third, the shale gas revolution led to low gas prices, placing much more gas-fired power “in the money” for more extensive parts of the year. All these factors led to a considerable increase in the use of natural gas in the electricity generation sector of the economy.
Natural Gas Position Energy Hedging Examples
Any company, city, power plant, or other entity that has an ongoing need to purchase natural gas carries an inherent exposure to price risk. For example, the profitability of a chemical plant using natural gas as a feedstock to produce fertilizer is at risk if some technique is not used to stabilize gas costs.Any company, city, power plant, or other entity that has an ongoing need to purchase natural gas carries an inherent exposure to price risk. Click To Tweet
Financial hedging is the practice of using financial tools to lock in gas prices in the coming months to reduce uncertainty in costs; the mid-office function often undertakes this. The term “hedge” is a literal reference to the practices farmers and ranchers have used for centuries for delineating different property lines, pastures, and meadows. Thick bushes are planted along the boundary, and as they grow, these hedges are pruned shaped into impenetrable barriers, keeping livestock in and predators out. As a result, the farmer’s animals have limits to their environment beyond which they cannot go.
Just as in the farmer’s property image, a financial hedge is used to keep gas prices within certain boundaries in some future period (usually a month). Let’s look at an example.
Amy is a fuels manager in the mid-office at a company with a predictable gas usage pattern (see graphic). It is now January, but she is already focusing on December requirements, which are forecast to be near 8 million MMBTU. December usage is also known to vary wildly – the weather is sometimes cold and sometimes mild, but Amy rarely needs less than 5 million MMBTU. Together with her management, Amy decides she will hedge this quantity.
There are numerous tools available to Amy to accomplish this hedge.
- Financial exchanges such as NYMEX (CME) facilitate the purchase and sale of futures contracts for various commodities such as natural gas, oil, diesel, agricultural products, and more. Simply put, the exchange serves as a clearinghouse for willing buyers and sellers to transact an astonishing array of financial products. Since futures prices change continually, the exchanges track the difference between an instrument’s strike price and the current market price (the mark-to-market). In addition, the margin is either collected or paid out to instrument holders daily so that at settlement, both the buyer and the seller are flat with the exchange.
- Over-the-Counter (OTC) transactions are available to lock in a future price, but directly between a buyer and a seller, without an exchange in the middle. These forward transactions accumulate MTM until settlement when the buyer either pays or is paid an accumulated margin.
Amy chooses to contract with a Hedge Counterparty (CP) to purchase forwards for December at a set price. For natural gas, forwards are sold in contracts, with each contract being comprised of 2,500 MMBTU. She purchases 2,000 contracts at $3/MMBTU to acquire the 5,000,000 MMBTU she wants to hedge. This infographic summarizes the transaction.
In this way, Amy has locked in $3 gas for December for the quantity she hedged. Two critical points are relevant here:
- This transaction is entirely financial; no gas has changed hands. The three scenarios from the table show possible outcomes. If physical gas for December is priced at $3 exactly, that’s the price Amy will pay for her 5 million MMTU, and she has protected the $3 price target to which she and her management agreed. If the market price declines to $2.50, she buys physical gas at $2.50; she will still be obligated to pay her hedge CP the $.50 difference. Finally, if the market price has risen to $3.50, she buys her physical gas at $3.50, but the hedge CP pays her the $.50 difference, and she has protected her target price of $3 for December.
- It’s assumed that Amy will now buy 5 million MMBTU of baseload physical gas for December at the market price and accomplish her goal. This move is good if she is confident that she will need this quantity. Her forecast showed an 8 million MMBtu requirement. The extra gas she needs above her baseload of 5 million MMBtus may be purchased each day at the spot price. This move will expose Amy’s company to daily changes in prices, but only for the quantity of gas over and above her baseload amount.
Let’s examine a power trading example. Amy’s mid-office co-worker Robert trades power off his company’s combined-cycle plant in Texas. His plant has an average Heat Rate of 7.1, and his gas supply contracts are priced at the Houston Ship Channel. A purchaser wants 200 MW of fixed-price power in September, around the clock. The current broker sheets are showing September ATC at $23.50/MWH. Can Robert execute this trade profitably?
If Robert chooses to sell this product, a prudent hedge strategy may be to sell fixed-price power but hedge gas equivalent to secure production costs. He, therefore, contacts Amy and asks her to buy September futures (1,022,400 MMBtu or ~100 contracts) at $3.
This simple example has left out several other price risk factors, but it does show the use of energy hedging for one commodity (gas) to fix the costs of another commodity (power).
Gas Mid-Office Risk Management Program
Many companies address their systemic risk to price uncertainty by establishing well-defined programs and governance for risk management. Based on the organization’s industry, risk position, financial strength, and risk tolerance, best practice mid-office programs typically include several different strategies and tactics for entering into financial energy hedging transactions for specific purposes.
Programmatic purchases. Like dollar-cost averaging, the organization makes systematic, periodic purchases of futures or options for a given future month. Thus, a portion of a future requirement is accomplished on a schedule regardless of the price. For example, instead of purchasing all 2,000 contracts at once, Amy could have purchased 200 contracts each month for the ten months preceding December.
Opportunistic purchases. This process involves purchasing additional positions when the price drops to a pre-determined level. For example, Amy uses the Programmatic approach to fill her December requirement, buying 200 contracts per month. However, she does have an Opportunistic target of $2 for December, so if the December price drops below $2 any time during the year, she is authorized to buy additional forwards off-schedule. This tactic takes advantage of downward price movement.
Defensive. To protect against unexpected upward movement in prices, this tactic involves purchasing additional positions when the price rises above a pre-determined level. Again, Amy is purchasing 200 contracts a month, trying to average $3 for December dollar cost. However, she is authorized to purchase additional contracts if the price rises above $4 to protect against exposure to even higher prices.
Seasonal swaps. If Amy’s company has physical gas storage, she can use financial products to optimize the storage asset operations (sometimes called calendar swaps).
Mid-Office Best Practices
In most companies, the successful natural gas price risk management program involves many transactions of numerous types. Deals with hedge counterparties and exchanges can be numerous and complex, and there is the ongoing need to calculate the MTM value of each. Plus, the hedge cost or gain must be tied out with the corporate accounting system at settlement. PCI’s Energy Trading and Risk Management platform seamlessly manages all the functions needed to accomplish this, from deal capture through accounting tie-out. Daily analysis of market movement presents current positions and margin obligations. In addition, roles for trader, manager, and risk manager are integrated into the solution.
The third blog will describe how physical and financial transactions and other market activities are settled and tied out with corporate accounting processes.
Learn more about our ETRM solution:
ETRM – Gas Management Best Practices: A Two-Part Blog Series
- Part 1: Tracking Natural Gas Production Needs a Comprehensive ETRM Solution
- Part 2: Natural Gas Mid-Office Functions & Energy Hedging < You are here
Terms to Know
Volatility: rapid changes in price in the short term (days and weeks) due to temporary factors such as weather and mechanical disruptions of supply.
Price movement: longer-term price changes due to fundamental and systemic reasons such as economic cycles, technology change, or political influences.
NYMEX (CME): The New York Mercantile Exchange merged with the Chicago Mercantile Exchange in 2008 to create the world’s most extensive financial derivatives exchange. Now called CME Group, the term NYMEX is still used in referring to this organization.
Strike price: the price at which a financial product is bought or sold. Amy’s hedge had a strike price of $3.
Mark-to-Market (MTM): the general way a transaction is valued after being consummated but before settlement. The strike price is compared to the current market price, and the MTM is either positive or negative.
Margin: each day, the exchanges will calculate the MTM of a transaction and either collect or distribute the difference from position holders. If there is no MTM at the time of settlement, this is called being flat.
Hedge Counterparty: business with whom OTC transactions are made. Whereas there usually is no daily margining, counterparty credit is a factor.
Heat Rate: typical efficiency factor used for fossil-fueled power plants. The heat rate is usually denoted in the form of MMBtus/MWH and allows quick calculation of fuel costs for a unit of electricity.