Jul
11
2018

Hedging 101, Part 2

This week, we continue our conversation with hedging expert Andy Whitesitt. Over two decades, and as a senior executive with ACES, he’s helped dozens of utilities smooth cost curves and mitigate risk. Hedging helps consumers across the country every day. 

What’s the difference between financial hedging and physical hedging?

Financial hedging is locking in only the price risk by utilizing either a futures contract or a swap. After locking in the price, the utility still must go out and procure the natural gas needed to run the generation unit.

Physical hedging is a purchase of physical gas to be delivered to a specific location at a specific price. Physical hedging locks in both the price and the supply. Another way to hedge physical gas is to purchase natural gas reserves – in other words, natural gas still in the ground, yet to be produced. If natural gas prices increase, the utility can produce the natural gas for consumption or to sell and offset the price of other gas purchases.

Who are typical counterparties for utility hedges?

Counterparties change over time based on who is most active in the market, meaning they are constantly in the market showing bids to buy natural gas futures and offers to sell natural gas futures. Their goal is to transact with utilities, or other end-users, and producers. Usually these are banks, global oil and natural gas producers and marketers, or companies that transact in the markets, taking risks to generate income.

How long has hedging been part of utility business practices? 

Natural gas futures contracts were first introduced in 1990 and quickly became a widely-used tool for hedging price risk. However, utilities have long signed into fixed price coal contracts or long-term power price agreements to hedge price and supply risk. For the past two decades that I’ve been involved in the electric utility business, hedging has been a common and well-utilized tool for utilities to reduce potential risks associated with providing consumers with electricity.

How many years ahead do utilities hedge?

In my experience, the average utility hedges anywhere from 1 year to 5 years in the future with the overall average being closer to 3 years. However, some see the wisdom in going out 10 years in the future.

Why hedge when natural gas futures prices are so low?

As we look to the future, natural gas prices can be locked in at less than $3.00/MMBtu for the next 10 years. Many believe natural gas prices will remain this low forever. However, there are fundamental factors that it is prudent to analyze and weigh. The US is producing much more natural gas than we can use. However, much of that supply growth comes from a small number of counties in Pennsylvania and as a byproduct of crude oil production.

It’s important to recognize this doesn’t provide a very diverse supply portfolio for the years ahead. Additionally, the U.S. has just started exporting natural gas to other countries as Liquefied Natural Gas (LNG) and is quickly shipping more and more natural gas to other markets. This could increase demand and subject the US natural gas market to global market prices outside of our control.