Hedging: Freedom from Worry

Recently, Energy Fairness asked Andy Whitesitt, Vice President of Business Development & Customer Service at ACES, to talk with us about hedging basics.

We hope the following Q & A interview will help you understand how utility hedging programs work to remove some worry about future costs. Next week, we’ll follow up with some additional insights about this common business practice many utilities routinely deploy to protect consumers.

Can you provide a 101 explanation of hedging?  

Hedging is simply locking in the price of a commodity in order to reduce the risks of potential impacts. When electric utilities use natural gas to fire a power plant, the price of electricity generated and passed on to consumers is directly impacted by the price of natural gas.

Natural gas has historically been a volatile commodity. To reduce potential volatility of the ultimate rates and bills paid by consumers, a utility can hedge the price of the natural gas or in other words, lock in the price, so short term price fluctuations have less of a chance to impact overall electricity prices.

Where do hedges take place?  

In order to hedge the price of natural gas, utilities often look to the futures market. The futures market allows utilities, producers and other market participants to transact for natural gas and other commodities for future months. The most liquid futures market for natural gas is the Henry Hub in Louisiana. However, there are other locations around the country where gas is purchased and sold based on where the gas is produced or delivered to. These “natural gas hubs” can also be hedged with what are called basis hedges. Basis is simply the difference between the price of the benchmark Henry Hub contract and the price at the location where the gas is physically being purchased and sold.

What does the term “futures contract” cover?

A futures contract is a standardized contract for a specific volume and specific time period in the future that is traded on an organized exchange. For example, natural gas futures can be traded on the NYMEX which is a part of the Chicago Mercantile Exchange. The Henry Hub futures contract traded most frequently is equal to 10,000 MMBtu. It can be traded for each individual month in the future and settles against the Henry Hub monthly index in Louisiana.

What are some other terms and concepts important in hedging? 

In addition to the standard futures contract, many utilities utilize swaps to hedge commodities. A swap contract is a contract between two counterparties based on mutual agreements. Swaps can be customized to any volume, settle at any location, and can be transacted for any time period in the future.