FINANCIAL INSTRUMENTS HELP PRODUCERS HEDGE GAS DEALS IN VOLATILE MARKET

James N. Lawnin, Suzanne L. Kupiec
Ernst & Young
Houston

The marketing of natural gas has radically changed over the last few years.

The Natural Gas Policy Act (NGPA) of 1978 and more recently the U.S. Federal Energy Regulatory Commission's Order 636 have changed gas marketing from a totally regulated industry to one that responds to free-market forces. The stable but controlled market in which producers once sold gas has become highly competitive and more efficient.

Consequently, prices have become more volatile; they respond more quickly than they did before to changes in supply of and demand for natural gas.

Prior to deregulation of the natural gas industry, producers had fewer marketing options than they do today. Under a tropical gas sales contract, producers sold gas to the nearest pipeline at regulated prices, which remained relatively stable along the interstate distribution chain. The system however failed to generate adequate supply of gas.

In an effort to realign supply and demand, Congress initiated the deregulation of natural gas with NGPA, which phased out most wellhead price controls. A series of FERC actions culminating in Order 636 extended the process.

Now, independent producers can sell gas directly to end users. Under Order 636, interstate pipeline no longer offer merchant services to gas customers.

RISK PROFILES CHANGE

Deregulation has resulted in materially different risk profiles for each of the traditional segments of the industry: producers, pipelines, local distribution companies (LDCs), industrial gas users, and marketers.

In the traditional gas sales contract, pricing and credit risk were less important than they are today. pricing regulation, while inefficient, provided stability of cash flows and revenues. Prices in today's environment are more volatile; consequently, producers who sell on the spot market have an extremely difficult time forecasting cash flows and revenues.

A major development in the management of price volatility risk occurred on Apr. 3, 1990, when the New York Mercantile Exchange (Nymex) began trading the natural gas futures contract. Since its inception, the market toy the futures contract and the related natural gas options contract has expanded considerably.

The market for off-exchange financial instruments, such as forward contracts, natural gas swaps, and natural gas options, has also exploded in recent years. These financial instruments offer risk management opportunities not previously available.

Prior to these instruments, risk management depended heavily on finding counterparties with offsetting positions and executing back-to-back deals, allowing a company to lock in a profit by matching a contract to buy with a contract to sell.

The new financial instruments, both on and off the Nymex allow companies to hedge their price exposure by transferring risk to other companies with inverse risk profiles.

The producer is inherently long; that is, he owns reserves that will be produced and delivered some time in the future. The producer who sells gas under a spot contract has no means of guaranteeing what his production will be worth in the future. If prices decline, his survival may be in jeopardy.

Financial contracts give the producer the ability to lock in prices for future delivery. A general decline in spot prices will cause a decrease in the producer's revenues, which can be offset by gains from financial instruments hedging the production.

PRICE PROTECTION

For example, a producer might anticipate selling I million MMBTU of natural gas next month. He also anticipates that spot prices next month will average $2/MMBTU. There is a chance, however, that spot prices could go as high as $2.50/MMBTU or as low as $1.50/MMBTU.

A decline in prices would have a serious impact on the producer's operating cash flow. In order to reduce risk, the producer sells 100 futures contracts for delivery next month at $2/MMBTU.

If next month's spot prices do in fact decline to $1.50/MMBTU, the producer has a loss in value of $500,000 (the price difference, 50/MMBTU, times 1 million MMBTU). Therefore, by hedging price exposure, the producer has minimized an adverse impact that declining prices might have had on his operations.

Hedges thus can be used by producers to manage price uncertainty. These financial instruments, if used properly, can reduce potential losses.

Since banks and investors require higher rates of return for assuming higher risks, the implementation of a hedging program reduces price exposure and the corresponding risk to banks and investors. When a company manages price risk exposure, banks may be more willing to lend more money against reserves or reduce lending rates.

Likewise, investors require lower rates of return because they, too, are exposed to less risk.

The merits of having a hedging strategy are clear. However, the mechanics of the financial instruments require further explanation. Following is a review of financial instruments traded on the Nymex (futures and options) and off of the Nymex (forwards, over the counter options, and swaps). These are the primary financial instruments used by companies to hedge natural gas operations.

FUTURES, OPTIONS

Natural gas futures contracts are traded on the Nymex and may be bought or sold.

Contracts bought result in a "Ion-" position for the contract holder, contracts sold a "short" position. Each futures contracts represents an obligation by the contract holder to either buy of sell 10,000 MMBTU of natural gas.

Trading of natural gas futures contracts extends 18 consecutive months into the future with the initial trading month typically being the next calendar month. For example, in September the earliest contract that may be purchased would be for October delivery.

However, 6 business days prior to Oct. 1, trading of the October contract will cease, resulting in November delivery contracts being the front month contract.

What happens when October contracts are about to come off the board (i.e., stop trading) and a contract holder is long October natural gas futures contracts?

The holder has two choices: take an offsetting position or take delivery of the 10,000 MMBTU of gas.

Offsetting positions are most commonly used to close a position. For example, when a futures contract is bought, it is designated an open position, meaning that it is not matched with a futures contract to sell natural gas in the same delivery month as the long contract

If a contract to sell natural gas is executed with the same delivery month as the long contract, these contracts may be matched and closed; the positions have then been offset- When positions are offset, physical delivery does not occur, and the contract holder realizes a net cash gain or loss when the contracts are closed.

If positions are not offset, physical delivery may be required. Financial performance is guaranteed by Nymex.

The delivery point for natural gas futures contracts is Sabine Pipe Line Co.'s Henry Hub in Louisiana. The seller is required to pay the Hub fee and move the gas through the Hub, while the purchaser is responsible to move the gas from the Hub. Product specifications must conform to effective pipeline specifications at the time of delivery.

Natural gas futures contracts are commonly used to hedge a company's price risk, which exists whenever the price change results in an adverse financial impact. By hedging price exposure, risk of financial loss can be reduced by utilizing a natural gas futures contracts

HEDGED EXPOSURE

For example, if 10,000 MMBTU of natural gas inventory is acquired in September but will not be sold until October on the spot market, the inventory owner has price exposure: If natural gas spot prices fall below the cost of the inventory prior to sale, a loss will occur.

However, the inventory owner can hedge the price exposure on his inventory by selling an October natural gas futures contract. Table 1 illustrates holding price risk exposure declined via this tn,pe of hedge.

It shows that hedging reduces price risk exposure. If the inventory owner executed the futures contract on Sept. 1, the price decline and resulting inventory loss on Sept. 5 is fully offset by the gain on the futures contract.

In addition, the example could be classified as a perfect hedge because each dollar of inventory loss is offset by a -am on the futures contract. In reality perfect hedges are scarce because spot market prices and Nymex prices do not always move together. However, the table illustrates that without any type of hedge the inventory holder would have realized a $400 loss. Transaction costs are excluded.

The Nymex offers another hedging vehicle, the natural gas options contract. Purchasers of natural gas options have the right but not the obligation to purchase or sell a natural gas futures contract at a specified price within a specific time period.

The specific price is known as the strike price, the price at which the underlying futures contract may be bought or sold. The time period designates the (delivery month of the underlying futures contract.

Options trading ceases the Friday before the underlying futures contract expires as long as 3 trading day's remain for the futures contract. If 3 trading days do not remain, the second Friday prior to futures expiration is the last trading day for natural gas options. Natural gas options are traded 12 consecutive months into the future.

Two basic types of options may be bought or sold: puts and calls. A put is an option to sell; a call is an option to buy.

Therefore, the purchaser of a put is short while the seller (also known as the writer) is long. Likewise, the purchaser of a call is long the seller, short.

When an option is purchased, a premium is paid to the option's writer. The premium is an up-front, onetime payment that represents the market value of the option and is based on four variables: the strike price of the option in relation to the underlying futures contract price, price violability of the underlying futures contract, time remaining before option expiration, and interest rates.

Unlike futures contracts, the option purchaser can allow the option to expire. The decision to let an option expire means that the option purchaser lets his option expire worthless and does not recoup any of the premium paid to purchase the option. Option purchasers can also exercise the option, meaning that the option purchaser is exercising his right to purchase a futures contract.

Financial instruments such as options can facilitate property sales when the purchaser and seller have different views of future prices.

SETTING PRICE FLOORS

Gas producers can purchase put options to effectively set a floor on sales prices.

For example, if a producer estimates in October that he will have 500,000 MMBTU of gas available to sell in December and does not want to lock in a sales price (as would a short futures contract) but does want to set a minimum sales price, he could purchase 50 puts. The producer might choose this strategy if he anticipates that the December natural gas futures contract price is more likely to rise but still needs protection from falling prices. Table 2 illustrates this example.

It shows that 50 puts were purchased and that premiums of $41,500 were paid. The producer chose to let the puts expire because he could sell his gas at $2.75/MMBTU a price well above the puts' strike price of $2.35/MMBTU.

The opportunity cost of this example is $41,500, the premium paid. Because the producer chose to hedge against a potential price drop, he had to pay $41,500 for this hedge, which decreases his natural gas sales revenues.

However, if the price of December natural gas futures on NoN,. 12, 1993, had been $2.25/MMBTU, the producer could have exercised his put options and realized an $8,500 gain over spot market prices [($2.35-$2.25) x 500,000 MMBTU - ($41,500 premium)].

OFF-EXCHANGE CONTRACTS

Off-exchange contracts include forwards, over the counter options, and swaps. They are commonly referred to as cash market contracts.

Because no exchange regulates cash market contracts, the counterparties to the contract determine all details of the contract: quantities, prices, product specifications, delivered dates, delivery locations, etc.

Absence of exchange regulations in the design of financial contracts can offer unique advantages. Cash market contracts can extend for much longer periods of time; some natural gas forward contracts are for 20 year delivery terms.

In addition, the counterparties can tailor the cash market contracts to the specific needs of the companies.

Forward contracts are essentially the "futures contract" of the cash market. Forward contracts represent an obligation to make or take delivery of natural gas in accordance with the terms of the contract.

For example, a natural gas producer may enter a contract with a natural gas marketer to sell his natural gas. The quantity, pricing, delivery date, payment date, and all other contract information will be agreed upon between these two parties.

The pricing structure of the contract may be tied to market rates or may be fixed and flat. If the price is fixed and flat, the marketer has price exposure and can hedge his price exposure by selling a natural gas futures contract. In doing so, the marketer protects himself from prices falling below his purchase price. Table 3 illustrates this scenario.

If the market price of the futures and forward contract goes to $2.15/MMBTU, the marketer will realize a 5/MMBTU loss on the forward contract offset by a mit/MMBTU gain on the futures contract for a net 2/MMBTU gain on the strategy. If the marketer had not hedged the forward purchase contract, he would have realized a 'c,'MMBTU loss.

Over the counter option contracts are derivative financial instruments that are essentially structured like exchange-traded options except that the specifics of the over the counter contract are determined by counterparties, such as banks or energy traders.

Hedging strategies utilizing over the counter options are the same as those for exchange-traded options. For example, a marketer may identify that the maximum purchase price that allows an adequate profit is $2.25/MMBTU. Buying a call option with a $2.25/MMBTU strike price effectively sets a purchase price ceiling locking in the necessary profit.

Again, the additional risk in executing an over the counter option as opposed to an exchange-traded option is that the writer of the call may not be able to fulfill the sales obligation.

Financial swaps are another derivative financial instrument used to manage price risk exposure. One type allows a company to "swap" a fixed price payment stream for a market-price-related payment stream.

Like all other cash market contracts, terms of a swap agreement are determined by the counterparties. The significant terms to be agreed upon are: duration of the swap agreement, settlement periods, quantities, market price index and the fixed price.

An example: A natural gas marketer currently has a contract to sell natural gas for the next 5 years at market price but would prefer to sell gas at a fixed price. Therefore, the marketer executes a swap agreement with a bank, as described in Table 4, to effectively sell gas at a fixed price.

At the end of each quarter, the marketer will "pay" the bank the market price index (as calculated for that quarter), and the bank ",ill "pay" the marketer $2.50/MMBTU. If the first quarter of 1993 has a market price index of $2.25/MMBTU, then the marketer will pay the bank $2.25/MMBTU and receive $2.50/MMBTU, realizing a 25/MMBTU gain.

In practice, the marketer and the bank do not pay each other the gross amounts of the swap; rather, a net payment is made. In the example, the bank would have paid the marketer $250,000, calculated as follows: [($2.50-$2.25) x 1,000,000].

RISK CONSIDERATIONS

Understanding the mechanics of financial instruments and derivative products is one crucial step in implementing a hedging program. There are, however, additional risks that can occur in the execution of a hedging strategy.

All of the foregoing examples assumed that we were hedging natural gas sales and purchases with natural gas financial contracts having similar characteristics. To manage a dynamic hedge portfolio, it is not possible to hedge this way.

For example, forward contracts to purchase natural gas in Pennsylvania may be hedged with a futures contract to well natural gas in Louisiana. Natural gas prices in Pennsylvania do not always move in tandem with natural gas prices in Louisiana. This situation is known as location basis risk.

When evaluating the effectiveness of a hedge, it is important that the value of the hedge offset the gain or loss in the value of the commodity being hedged.

If the hedging instrument's price moves closely with the price of the gas being sold, price correlation has been achieved.

In addition, the stated quantity or contract size of the hedging instrument must reflect the volume to be hedged.

If the correct quantity of hedging contracts is purchased and the hedging contracts are highly correlated with the producer's hedge, then the hedging instrument will be effective.

In addition, the stated quantity or contract size of the hedging instrument must reflect the volume to be hedged.

If the right amount of hedging contracts is purchased and the hedging contracts are highly correlated with the producer's gas then the hedging instrument will be an effective hedge.

Management's objectives may not be met and additional risks may be added if the hedge is not properly designed.

There are a number of considerations a producer must make to establish the proper hedge.

The risks that a producer must consider in establishing an effective hedge are basis risk, location risk, cross-hedging risk, credit risk, timing risk, and volume risk.

If these risks are not identified and properly managed, the hedging instrument may be counterproductive and may increase the producer's exposure to risk.

TYPES OF RISK

The spread between the price of the futures contract and price of the commodity in the spot market is called the basis.

The amount of the basis for natural gas depends on the level of the borrowing rate, the storage cost, and the time until settlement. Since these factors can fluctuate in an unpredictable manner, so will the basis amount.

Suppose a producer enters into a futures contract to lock in a price of $2.25/MMBTU for next year's delivery. Assume the current spot price is $1/MMBTU. The basis is therefore 25.

Tomorrow the spot price might decrease to $1.75, while the futures price might decrease to $2.20. The basis has increased from 25 to 45.

The producer would not be completely hedged in this situation. He would have a loss in value on the spot market of 25 ($2-$1.75). His gain on the futures contract, however, Would be only 5 ($2.25-$2.20). The net loss is the increase in basis, or 20/MMBTU.

Another type of basis risk is location basis risk. k producer who sells gas on the spot market at a location different from that of the hedged instrument will have location basis risk. Sudden local shifts in supply and demand can change the pricing relationship between two markets.

Assume a producer wants to lock in a price of $2.50/MMBTU for next year's delivery. The producer expects to deliver 16 million MMBTU next year to a pipeline in West Texas.

To hedge his price risk he sells Nymex futures contracts. At the time of delivery, however, the spot price for Henry Hub is $2.25/MMBTU and the spot price for West Texas gas is $1.90/MMBTU.

The producer would have a loss in value of 60 on the spot market ($2.50-$1.90). His gain on the futures contract, however, would be 25 ($2.20-$2.25). The net loss would be 35 (60-25).

The producer might have thought that he had locked in a price of $2.50/MMBTU, but in reality he only received $2. 15/MMBTU ($2.50-$.35). Fig. 1 shows how volatile gas prices in different regions can be in comparison with Henry Hub prices.

Cross hedging is when the commodity underlying the hedging instrument is different from the commodity being hedged. It is generally used when there are no futures contracts on the commodity being hedged.

For example, a producer of a gas condensate field may want to hedge his production. Since there isn't a futures market for ethane, the producer may decide to use the natural gas futures market instead.

The producer might use cross hedging to lock in an ethane price of 25/gal for next year's delivery.

If ethane Historically trades at a 1:9 ratio to natural gas-dollars per million BTU of gas vs. cents per gallon of ethane-the producer may decide to sell one natural gas futures contract to hedge 90,000 gal of ethane when the price of the futures contract is 52.25/MMBTU (25/gal x 9). The value of 90,000 gal of ethane is equivalent to 10,000 MMBTU, the quantity of one natural gas futures contract.

If the relationship between ethane and natural gas prices remains constant, the loss in value in ethane prices will be offset by the gain in the futures contract.

For example, if ethane decreases by 5/gal and the pricing relationship between natural gas and ethane remains the same, natural gas prices will have decreased by 45/MMBTU.

Thus, the loss in value of selling the ethane on the spot market is offset by the gain in the natural gas futures contract. If the price relationship does not remain constant, the producer may not fully offset the ethane spot market loss with a gain on the gas futures contract, or the futures gain could exceed the spot market loss.

The risk to the producer thus is that the pricing relationship between ethane and natural gas prices shifts before the time of delivery (Fig. 2).

Two important risks to a producer or to a marketer are timing risk and volume risk.

Timing risk is the risk that the item being hedged will not be delivered in the expected time frame. A producer might enter into a hedging contract to deliver 10 million MMBTU of -,is next year because he wishes to lock in a price for production from a new offshore field. He enters into a futures contract to sell at $2.50/MMBTU.

Unfortunately for the producer, mechanical problems or environmental regulations prevent him from bringing the field on line as expected. If prices rise suddenly to $3/MMBTU, the producer has a loss on his futures contract of 30/MMBTU, or S:; million, and no offsetting gain in value from spot sales. Prices may have retreated back to 52.50/MMBTU when the producer is finally able to deliver his gas.

Volume risk is similar to timing risk. It is the risk that the volume of the hedging instrument differs from the item being hedged.

A producer might enter into a forward contract, agreeing to deliver and sell a certain quantity of production or reserves. If production or reserves are less than originally forecast, the producer has the exposure of having to purchase make-up deliveries to fulfill his obligation under the contract. The producer will have a loss if the price paid for the make-up gas is more than the forward contract to sell.

One of the marketer's largest risks comes from not being able to successfully balance and offset their positions. There is financial risk to the marketer if his positions are not closely matched in volume and timing.

If for some reason one of the counterparties is unable to fulfill its obligation, the marketer will be exposed to a volume or timing risk that it did not expect.

It is crucial, therefore, that producers and marketers constantly monitor their positions against their production forecasts and reserve estimates to prevent being exposed to these risks.

BUSINESS CONTROLS

Business controls applicable to hedging activity include hedge committees, management reports, back office controls, daily reconciliations, and credit monitoring.

While this is not an exhaustive list of the business controls that could be put in place over hedging activity, it includes some of the primary methods used by most companies.

In addition, companies engaged in hedging operations should periodically review their current business controls to ensure they are adequate.

A key role planned by management in monitoring hedging activities is the creation of a hedge committee to oversee hedging activities and approve hedging strategies.

For example, the committee might determine that no less than 20% and no more than 70% of inventory, should be hedged with contract durations of no more than 6 months. The committee may also require a price sensitivity analysis of underlying risks in the portfolio positions.

Personnel on the hedge committee normally are from senior management in the financial and operational groups of a company. Knowledge of both the risks and regards of all hedging strategies is essential for an effective hedge committee member.

While hedge committees and price sensitivity analyses are excellent controls, they are only as good as information management receives daily.

Historically, obtaining accurate' information on a timely basis is one of the most significant 'challenges that a company has ",hen implementing trading and hedging controls. The main building block for an effective position monitoring system is the daily generation of a position monitoring report, which can be used by management as a comprehensive risk analysis tool.

The typical position monitoring report lists all open positions and their pertinent characteristics, including the current market value of each open position. Once a report has been designed, it should be updated and reviewed regularly by management.

BACK OFFICE COMPELS

The back office monitors trading activity in the execution and clearance of natural gas contracts. However, the effectiveness of the back office may be hindered in the current marketplace by the volume of transactions and uniqueness of financial instruments.

The volume of transactions in a stimulated marketplace can be multiples of volumes during normal activity. Such an extreme increase in activity occurred during the Persian Gulf crisis of 1990.

In addition, the structure of financial instrument; changes dairy in response to the risk management needs of a sophisticated market place.

For the back office to effectively meet these challenges, management must ensure that the back office is adequately staffed and trained and that it has access to independent sources of information,

Daily broker reconciliations are another key control to monitor Nymex activity. Here, a company reconciles the net worth of the brokerage account per the company to the net worth of the brokerage account per the broker.

The net worth of a company's worker account is cash on deposit 'plus the net unrealized gain or loss on futures plus the net open option market value. Cash on deposit consists of initial mar-in and maintenance margin.

When a futures position is opened, the broker will require the company to deposit an initial margin. Broker require maintenance margin to cover losses created by adverse price movements on open positions.

By reconciling broker accounts daily, the company ensures that the broker and the company agree on cash deposits held by the broker and that the broker and the company have consistently recorded open positions.

CREDIT MONITORING

A company must implement credit monitoring procedures to manage credit risk: the risk that a counterparty to a non-exchange traded contract will not perform. Credit risk increases in relation to duration of the contract and creditworthiness of the counterparty.

As with all risks, credit risk must also be monitored on a regular basis, and companies should know each day what their exposure is with all counterparties. In addition, companies should have credit limits for all counterparties. These credit limits should apply to a consolidated entity.

For example, if Company A has subsidiaries in America, Canada, and Mexico and Company B trades with the American, Canadian, and Mexican subsidiaries of Company A, then the credit extended should be monitored on a consolidated basis.

What companies should avoid is setting a $10 million credit limit for Company A and extending the same $10 million to three different subsidiaries of Company A. Ideally, credit monitoring should be done on a real time basis. In practices, this is rare.

However, traders should be updated daily as to credit extended to counterparties and which, if any, counterparties have reached their credit limits. In addition, credit monitoring personnel should be aware of all information that could affect the credit rating of their counterparties.

SUMMARY

Hedging is essential to managing risks in the natural gas industry,

The evolution of the industry to deregulation and a competitive market will force players in the industry to manage risks and maintain profit margins through hedging operations.

The industry has created financial instruments to allow effective hedging strategies. Companies in the natural gas industry must now choose to utilize those instruments and manage the risks in the execution of hedging strategies through effective business controls.

Copyright 1993 Oil & Gas Journal. All Rights Reserved.