November 1, 2008
Manage your exposure to volatile and rising prices for natural gases and other utilities.
by Mike Corley
In energy intensive industries such as aggregates, high and/or volatile natural gas prices can wreak havoc on the bottom line, not to mention the headaches incurred by management and shareholders.
While many companies in the aggregates business don’t consume as much natural gas as diesel fuel or electricity, most do burn enough gas that volatile prices and high expenditures can, and often do, have a significant impact on the company’s financials. If these volatile costs aren’t actively managed, they can lead a company to exceed budget forecasts, or worse, lower or non-existent profit margins.
Although there are many factors that affect natural gas prices, weather, natural gas storage inventories, and economics conditions, as well as the market’s perception of these factors, are the primary factors that drive natural gas prices.
Most large energy consuming companies such as those in the aggregates industry can mitigate their exposure to volatile and potentially rising natural gas costs, as well as diesel fuel and electricity costs, through hedging. Hedging allows market participants, such as aggregate producers which consume large quantities of natural gas and other energy commodities, to lock in prices and margins in advance, while reducing the potential impact of volatile and rising natural gas prices.
The primary reason that many large, natural gas-consuming companies hedge their natural gas costs is that the fluctuating price of gas can present large financial risks that have a significant impact on the bottom line. Another reason for hedging a company’s exposure to natural gas price risk is to improve or maintain the competitiveness of the firm. Very few companies are not subject to competition; they compete with other domestic companies in their sector as well as with companies located in other countries that produce similar goods for sale in the global marketplace. As a result, by having the ability to know and/or manage their future natural gas costs, many companies can establish a competitive advantage in their market.
Shifting the risk
Hedging reduces exposure to price risk by shifting that risk to those with opposite risk profiles or to investors who are willing to accept the risk in exchange for profit opportunity. Natural gas hedging involves establishing a position in a financial instrument that is equal and opposite of the company’s exposure in the physical natural gas market; the physical market is the “market” where a company procures the actual natural gas that it consumes in its day-to-day operations.
Hedging works because the cash prices and financial prices of natural gas tend to have a strong correlation. Even though the difference between the cash and financial prices may increase or decrease, the risk of an adverse change in this relationship is generally much less than the risk of not hedging.
It is extremely important to remember that the purpose of hedging natural gas is to mitigate the company’s exposure to natural gas prices, thus stabilizing the company’s natural gas costs. Hedging is not a means for a natural gas consuming company to gamble on the price of natural gas. Gambling on natural gas prices, also known as speculating, all too often produces worse results than doing nothing at all. Large gas consumers should use hedging to reduce the probability that the company will be negatively affected by volatile or rising natural gas prices. On the other hand, speculators are of the opposite mentality. Speculators bet on the direction of natural gas prices in hopes that they will be able to “buy low and sell high.”
Having said that, it is equally important to acknowledge the fact that if a company is not hedging its natural gas costs, it is effectively saying one of two things:
The primary instruments used to hedge natural gas are swaps, futures, and options. Natural gas futures contracts are firm commitments to make or accept delivery of a specified quantity and quality of a natural gas during a specific month in the future at a price agreed upon at the time the commitment is made. In the United States, natural gas futures are traded on the New York Mercantile Exchange (NYMEX).
Natural gas swaps are contracts in which two parties agree to exchange periodic payments for natural gas. In the most common type of a natural gas swap, one party agrees to pay a fixed price for natural gas on specific dates to a counterparty who, in turn, agrees to pay a floating price for natural gas that references a published price, such as the NYMEX natural gas futures.
A natural gas option contract is a contract that gives the holder the right, but not the obligation, to buy or sell a specified amount of natural gas (or a natural gas swap or futures contract) at a specified price within a specified time in exchange for paying an upfront premium. Breaking down the options even further, there are call options and put options. A natural gas call option is a contract that gives the holder the right, but not the obligation, to buy natural gas at a set price (the strike price) on a given date. A natural gas put option is a contract that gives the holder the right, but not the obligation, to sell natural gas at a set price (the strike price) on a given date.
Hedging in action
The following provides a simple example of how an aggregate company can use a natural gas call option to avoid an increase in natural gas costs while allowing you to obtain lower priced natural gas should prices decline. Assume that on Oct. 1, you anticipate that your natural gas demand for January will be 10,000 MMBTU (million British thermal units) and you want to ensure that your cost will not rise above the current market price for natural gas to be delivered during the month of January. As such, you decide to buy a call option on $9 January natural gas for $0.50. The current price for spot (cash) natural gas may be lower or higher than $9, but that is immaterial because you aren’t contracting for spot gas, you are buying an option on a contract for January natural gas. On Dec. 24, 2008 (the last day of trading before the option expires), you will have the ability to exercise the option if it is in your economic interest to do so. The figure below shows two possible scenarios: the January natural gas contract expiring at $7, or the January natural gas contract expiring at $11. It is important to note that regardless of where natural gas is trading in January, you will not pay more than $9.50 (including the option premium) for January gas due to the fact that you paid the upfront premium of $0.50.
In summary, there are numerous ways to reduce your exposure to volatile and potentially high natural gas prices, including futures, swaps, and options. By developing and implementing a sound natural gas hedging program, aggregate producers will not only be able to mitigate their risk to volatile natural gas prices, but will also be able to accurately forecast their natural gas costs and potentially provide their companies with a competitive advantage.
Mike Corley is the President of EnRisk Partners, LLC, a Houston-based energy advisory firm. He can be reached via the firm’s Web site at www.enriskpartners.com or by telephone at 713-970-1003.