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:

1. The company has the ability to pass on any and all increases in natural gas prices to its customers, without a negative impact on its profit margins; or
2. It is confident that natural gas prices are going to decline, and it is comfortable paying a higher price for natural gas, if in fact its analysis proves to be incorrect.

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.