Risk MGMT & Hedging Strategies in Natural Gas Industry

RISK MANAGEMENT AND HEDGING
STRATEGIES IN NATURAL GAS

INDUSTRY
1
INTR OD UCTION
Natural gas is made up principally of a chemical
called methane, a simple, compound that have a
carbon atom surrounded by means of four hydrogen
atoms.
Natural gas provides one-fifth of all the energy used

in the world.
It is especially important in homes, where it provides

nearly half of all the energy used for cooking,
heating, and for fueling other types of home
appliances.
2
USES OF NA TURA L G AS
Natural gas is adaptable source of energy, which can
be used by different sectors.
Heating and electricity generation have been the main
conventional uses.
Increasing environmental concerns may show the way
to a greater use of natural gas in transportation.
Residential users
 Residential applications are the most ordinarily known use
of natural gas. It can be used for cooking, washing and
drying, water warming, heating and air conditioning.
Commercial users
 Main commercial users of natural gas are food service
providers, hotels, healthcare facilities or office buildings.
Commercial applications comprise cooling (space
conditioning and refrigeration), cooking or heating.
3
Power Generation
 Electric utilities and independent power producers are more
and more using natural gas to provide energy for their power
plants. In general, gas fuelled power plants have lower capital
costs, are built faster, work more expeditiously. Technological
improvements in design, efficiency and operation of combined
cycle gas turbines and co-generation processes are privileging
the use of natural gas in power generation.
Natural Gas Vehicles (NGVs)
 NGVs are natural gas powered vehicles. Natural gas can be
utilised as a motor vehicle fuel as compressed natural gas
(CNG). Cars using natural gas are estimated to emit 20% less
greenhouse gases than gasoline or diesel cars. Natural gas in
vehicles is inexpensive and convenient.
4
NA TURAL G AS MARKET
In natural gas market gas is traded as a commodity,
separate from transportation services, in the form of
gas contracts. Although these contracts have
numerous dimensions, they are distinguished
primarily by the purpose of the transaction, whether
for physical delivery of gas or for management of
price risk.
Physical Gas Market

Financial Gas Market
5
FORMS O F N ATUR AL G AS
Liquefied Natural Gas (LNG)
LNG is natural gas brought down to a liquid state by cooling it to
-161°C. Once liquefied, the natural gas is more compact
occupying 1/600th of its gaseous volume. Natural gas is liquefied
since in gaseous form, it is extremely voluminous and cannot be
transported to long distances as gas field are far from the user
market. Liquefied form eliminates the need for more room for gas
transportation.
Piped Natural Gas

This is one of the classifications of natural gas use where natural
gas is utilized for domestic, commercial and institutional purposes.
Compressed Natural Gas (CNG)

CNG is a replacement for gasoline (petrol) or diesel fuel. It is
regarded to be an environmentally "clean" alternative to those
fuels. It is made by compressing purified natural gas, and is
typically stored and distributed in hard containers. 6
PURPOS E OF THE S TUD Y
Energy industry is not like other industries. No other
industry bestows such power on its producers. The
natural gas industry is marked by a very high degree
of price volatility.
Through the use of derivatives products it is possible

to partially or fully transfer price risks by locking-in
asset prices. As instruments of risk management,
these generally do not influence the fluctuations in the
underlying asset prices.
The emergence of the market for derivative products

can be traced back to the willingness of risk adverse
entities to guard themselves against uncertainties
arising out of fluctuations in asset price.
The main purpose of this study is to provide risk

management and hedging strategies to the natural 7
OB JEC TIVE O F TH E STU DY
Understand the working of derivative
contracts
To analyze factors constraining the

development of natural gas market
Study of the risk matrix in natural gas

industry
Study of natural gas contracts.

8
LITER ATU RE R EV IE W
Over the study of different research papers, it has been
found that every paper has different aspect to work out, as
the papers are written on problems faced by importers,
refiners, producers due to price volatility.
The lot of study had been done in the recent years;

Companies are doing lot of research on the upcoming
natural gas markets.
The research paper on which I have worked to understand

the whole process of hedging is ”Choices Among Alternative
Risk Management Strategies: Evidence from the Natural
Gas Industry” authors Christopher C. Géczy, Bernadette A.
Minton, and Catherine Schrand describe the
complementarities of a variety of risk management
strategies that firms can use to reduce price risk exposure.
The particular reference to the book Trading Natural Gas:

Cash, Futures, Options and Swaps by Fletcher J. Sturm is
imperative because it was helpful for the understanding of
9
the subject. The book by Fusaro, Energy risk management;
RES EAR CH METH OD OL OGY
Project is entirely based on the secondary data and
information available.
The collection of secondary data was via data available

on the internet, international journals & magazines,
international research papers, websites of the leading
exchanges. After organizing and presenting the data, the
research then has to proceed towards conclusion by
logical inferences.
The raw data is then analyzed:

VI. By bringing raw data to measured data
VII. Summarizing the data.
VIII.Applying analytical methods to manipulate the data so
that their interrelationship and quantitative meaning
becomes evident.
10
NA TURAL G AS: G LOBAL
PR OS PEC TIV E
Gas markets are poised for rapid growth. Energy
demand is speedily increasing and, spurred by
environmental considerations, natural gas has
become the quickest growing segment of the energy
market.
World Natural Gas Production (2007-08): 2940

BCM
World Natural Gas Consumption (2007-08):

2921.9 BCM
(World natural gas consumption rose by 3.1% in
2007) 11
NA TURAL G AS IN IND IA: A N
OVER VIEW
Gas occupies about 8.5% of the total energy basket
of the country.
Presently, fertilizers and power sectors remain to be

major consumers of natural gas at 29% and 40%
respectively.
At present, there is an acute shortage of gas in the

country. As against the current estimated demand of
about 150 MMSCMD, the availability is around 96
MMSCMD.
12
RISKS AND HED GING
Risk is concept that refers a potential negative
impact to an asset or some characteristics of value
that may arise from some present process or future
event.
There are five general types of risk that are

confronted by all Businesses:
 Market Risk
 Credit Risk
 Liquidity Risk
 Cash Flow Risk
 Basis Risk
13
NA TURAL G AS H ED GEING
Energy markets are the most volatile commodity
markets in the world due to dramatic changes in the
physical markets which are in turn influenced by
unpredictable weather patterns, political events and
dramatic swings in supply-demand balances. These
factors lead to tremendous price swings in short time
periods.
The deregulation and restructuring of the natural gas

industry in many industrial and developing countries
have led to the development of new markets that
have altered the way the industry operates.
Two major markets emerge as a result of deregulation:

the natural gas market, which facilitates the trading of
natural gas as a commodity, and the transportation
market, which enables market participants to trade
the transportation services necessary to ship natural
gas through the pipeline system. 14
Gas is traded like any other commodity on such a
marketplace.
Once there is sufficient liquidity, spot markets for

immediate and forward delivery emerge.
In places with a liquid forward market, futures

markets evolve to hedge exposure to price volatility.
Price volatility modifies the role played by traditional

flexible tools, such as storage, which is increasingly
used to maximise profits rather than simply to
manage volume.
15
FUTURES
A futures contract represents a legal agreement
between a party that opens a position on the
futures market to buy or sell natural gas at
commodity exchange.
In April of 1990, the New York Mercantile

Exchange (NYMEX) introduced and commenced
trading a natural gas future contract with the
Henry Hub in Louisiana as delivery location, and
in august, 1995 the Kansas City Board of Trade
(KCBoT) introduced and commenced trading a
western natural gas futures contract with Waha
hub in West Texas as delivery point.
16
SWAPS
A swap is custom-tailored, individually managed
transaction designed to manage financial risk,
usually over a period of 1 to 12 years.
Swaps can be carried on directly by two counter

parties or through a third party such as bank or
brokerage house.
The writer of the swap, such as a bank or

brokerage house, might elect to accept the risk
itself or manage its own market exposure on an
exchange.
Transaction helps each party to handle exposure

to natural gas spot prices.
17
OPT IONS
An options contract basically works like an insurance
policy. If a homeowner wishes to protect himself against a
risk, he pays an up-front premium. If the risk occurs, he is
recouped. If the risk doesn't take place, he is out nothing
but his premium.
The holder of an options contract has the right, but not

the obligation, to exercise his option. The seller, or writer,
of an options contract holds an obligation to perform if
called upon to do so.
There are two kinds of options: calls and puts. A call

gives the holder the right, but not the obligation, to buy
the underlying futures contract. Conversely, a put option
gives the holder the right but not the obligation to sell the
underlying futures contract. 18
FINDINGS A ND ANAL YSIS
DERIVATIVE INSTRUMENTS APPLICATION TO
INDUSTRY
Natural gas prices are now largely influenced by the forces of supply
and demand. Technical factors, such as pipeline capacity, as well as
fundamental factors, such as industrial use, influence prices.
Price risk and competition have also been driven all the way from
producers to resellers to the retail level.
Futures and options are used to address the needs and risks of six
important groups: producers, gas processors, interstate pipeline
companies, local distribution companies (or LDCs), marketers, and
end-users.
The futures market allows industry marketers to lock in a purchase

price for gas they have committed to deliver, or to lock in a selling
price, including a profit margin, for gas they have committed to buy.
19
PRODUCERS
Abnormal weather conditions

Uneven price movement
GAS PROCESSORS AND REFINERS
Gas processors can use natural gas and propane futures to

hedge the price risk of processing gas to extract propane.
Gas processors use “Frac” spread to lock in attractive
processing margin.
20
INTERSTATE PIPELINES
Interstate pipelines are subjected occasional to price risk.

Pipeline may be in a position where an alternative fuel, such as
oil, is less expensive, and the cost of gas transportation is a
critical factor in influencing the competitiveness of the
delivered price of gas.
END-USERS
Protecting against sharp price spikes which results in shortages

or delivery slowdowns.
Fixing short-term fuel costs.
Locking in an attractive spot price.
21
Hedging storage gas.
THE INVESTOR
Investors trade with risk capital.

They have no position in the underlying commodity and no
desire for one, so they have no vested interest in whether the
price moves up or down.
Investors seek to profit by correctly anticipating price changes.
The more often prices move significantly, the greater the
number of potential profit opportunities for the investor.
The natural gas futures market provides investors with many
attractive opportunities. Demand for gas is highly seasonal, but
the seasonal impact on pricing is unpredictable. Variables
include the severity of the winter weather, inventory levels,
producers' needs to generate cash to cover their expenses,
unexpected changes in demand for gas-generated electricity,
transportation prices and constraints, and the cost of natural
gas versus the cost of other fuels.
The last variable in particular can provide investors with
numerous trading opportunities in the form of inter-market 22
CONC LUSION
Natural gas is an attractive fuel: it burns cleanly,
producing little pollution, and its reserves are abundant.
Natural gas prices are now largely determined by the

forces of supply and demand. Technical factors, such as
pipeline capacity, as well as fundamental factors, such as
industrial use, influence prices.
Price risk and competition have also been driven all the
way from producers to resellers to the retail level.
The futures market allows industry marketers to lock in a

purchase price for gas they have committed to deliver, or
to lock in a selling price, including a profit margin, for gas
they have committed to buy. 23
The market is a liquid one, giving participants the ability
to enter and exit positions readily without disrupting
prices in the broader market.
Without futures, market participants must accept fixed-

price contracts, which can prove disadvantageous.
The futures market provides flexibility in forward

planning.
This flexibility is further enhanced by the options market

which provides participants with, among other things, the
ability to set price floors or ceilings, hedging against
adverse price movements while retaining the ability to
24
participate in favorable ones.
THANK YOU
25
Q AND A
26

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RISK MANAGEMENT AND HEDGING

STRATEGIES IN NATURAL GAS

Natural gas provides one-fifth of all the energy used

It is especially important in homes, where it provides

Physical Gas Market

Piped Natural Gas

Compressed Natural Gas (CNG)

Through the use of derivatives products it is possible

The emergence of the market for derivative products

The main purpose of this study is to provide risk

To analyze factors constraining the

Study of the risk matrix in natural gas

Study of natural gas contracts.

The lot of study had been done in the recent years;

The research paper on which I have worked to understand

The particular reference to the book Trading Natural Gas:

The collection of secondary data was via data available

The raw data is then analyzed:

World Natural Gas Production (2007-08): 2940

World Natural Gas Consumption (2007-08):

Presently, fertilizers and power sectors remain to be

At present, there is an acute shortage of gas in the

There are five general types of risk that are

The deregulation and restructuring of the natural gas

Two major markets emerge as a result of deregulation:

Once there is sufficient liquidity, spot markets for

In places with a liquid forward market, futures

Price volatility modifies the role played by traditional

In April of 1990, the New York Mercantile

Swaps can be carried on directly by two counter

The writer of the swap, such as a bank or

Transaction helps each party to handle exposure

The holder of an options contract has the right, but not

There are two kinds of options: calls and puts. A call

The futures market allows industry marketers to lock in a purchase

Abnormal weather conditions

GAS PROCESSORS AND REFINERS

Gas processors can use natural gas and propane futures to

Interstate pipelines are subjected occasional to price risk.

Protecting against sharp price spikes which results in shortages

Investors trade with risk capital.

Natural gas prices are now largely determined by the

The futures market allows industry marketers to lock in a

Without futures, market participants must accept fixed-

The futures market provides flexibility in forward

This flexibility is further enhanced by the options market

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