Natural Gas Hedging: Benchmarking Natural Gas Hedging: Benchmarking

Price Protection StrategiesPrice Protection Strategies

BackgroundBackground

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.

introductionintroductionEnergy 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 StudyObjective 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 StudyPurpose of the Study

To acquaint knowledge with

Natural Gas Trade

Natural Gas Contracts

Hedging instruments

LITERATURE REVIEWLITERATURE 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 CONTRACTSNATURAL 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 TYPES OF NATURAL GAS CONTRACTNATURAL GAS CONTRACT

Natural Gas

Contracts

Natural Gas

Contracts

Long TermLong Term

Short TermShort Term

Long Term Contracts

1. Fixed price, till the contract

lasts.

2. Future estimations of demand

and supply done.

3. Less risk.

4. With limited volume of

flexibility, it supports the

development of the natural gas

business.

Short Term

Contracts

1. More flexible contracts

2. Made on the basis of a single –

cargo or a number of cargoes

over a limited period of time

3. The price will either be fixed

when cargo is loaded or it may

be linked to an escalator

4. Risk of volatility and high

prices

Risk ManagementRisk 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 THE RISK MANAGEMENT PROCESSPROCESS

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 Risk Matrix in Natural Gas IndustryNatural Gas Industry

HEDGINGHEDGING

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?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 Hedging Principles ChecklistChecklist

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

What Factors Affect a Hedging Strategy?

HEDGING INSTUMENTSHEDGING INSTUMENTSHedging instruments include

Interest Rate Swaps Equity Options

Interest Rate Futures Equity

Swaps

Credit Default Swaps

Credit Options Commodity Swaps

Commodity Futures

Commodity Options

FX Futures

FX Options

Interest Rate Risk

Credit Risk

Currency Risk

CommodityRisk

Equity Risk

HEDGING STRATEGIESHEDGING STRATEGIES

ForwardsForwards 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

futuresfutures 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.

OptionsOptions 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 OPTION COMBINATION STRATEGIESSTRATEGIES

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.

SwapsSwaps

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 SPREADSENERGY SPREADSSpark 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.

ConclusionConclusion 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-to-

day market fluctuations in accordance with strategic

company objectives.