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 Short
Term Term
Long Term Contracts Short Term
Contracts
3. Fixed price, till the contract
lasts. 3. More flexible contracts
4. Future estimations of demand 4. Made on the basis of a single –
and supply done. cargo or a number of cargoes
5. Less risk. over a limited period of time
6. With limited volume of 5. The price will either be fixed
flexibility, it supports the when cargo is loaded or it may
development of the natural gas be linked to an escalator
business. 6. Risk of volatility and high
prices
 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 Interest Rate Swaps Equity Options

Rate Equity Risk
Risk Interest Rate Futures Equity Swaps

Credit Default Swaps

Credit Risk Credit Options Commodity Swaps
Commodity
Risk Commodity Futures
Commodity Options

Currency FX Futures
Risk
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-to-
day market fluctuations in accordance with strategic
company objectives.