Daily GPI / NGI All News Access

Economist: Utility Hedging Rethink in Order

The unfolding story of Lower 48 shale gas supply and the buildout of the nation's natural gas pipeline grid have done a lot to beat down gas prices and minimize volatility. So much so that one academic suggests in a new paper that some utilities and their regulators are out of step with the latest in price-risk hedging strategies.

"The natural gas industry has seen a dramatic turnaround in prices since 2008, with the prospect that shale gas may be able to supply the U.S. gas market adequately for decades at reasonable and more stable prices," National Regulatory Research Institute economist Ken Costello wrote in a new paper. "This market shift should have caused gas utilities to reevaluate their hedging strategies as these developments have unfolded, but it is not clear that all companies have done so."

In his paper Costello cites several examples of utility losses due to hedging practices that failed in recent years. Without naming names, he said one California utility lost almost $60 million during 2007-2008; another utility in the state had losses exceeding $37 million during 2008-2009. Also during 2008-2009, one North Carolina utility had losses of more than $156 million.

"Maryland utilities during 2008-2009 suffered losses in the tens of millions of dollars," Costello said. "Two South Carolina utilities have had losses in the tens of millions of dollars since 2006. Starting in 2006, four Michigan utilities accumulated large losses of around $1.6 billion."

Costello calculates losses from financial hedging as the difference between the hedged price and the prevailing market price multiplied by the amount of gas supply that was hedged. Losses highlighted in the paper generally resulted from the sale of put options by a utility and the subsequent unexpected decline of gas prices, Costello said.

"The utility had to compensate the buyer [of the puts] for the difference between the strike price and the market price," Costello explained. "Put options have the problem of mitigating downside price volatility, which is harmful to utility customers."

A utility would sell puts in order to offset the cost of buying call options, which are a hedge against rising prices.

Losses of the magnitude outlined in the paper have caused some regulators to question hedging programs, Costello said. He quoted a February 2011 document from the South Carolina Office of Regulatory Staff (ORS).

"'...Recent developments in domestic gas production and the correlating reduction in volatility in natural gas prices have eliminated much of the unpredictability which previously existed in the natural gas market,'" ORS said as quoted by Costello. "'ORS does not, however, believe that a permanent elimination of these hedging programs is warranted as environmental concerns regarding shale gas production may eventually result in federally mandated restrictions on domestic production.'"

Costello also cited a Federal Energy Regulatory Commission report that said pipeline capacity expansions had mitigated price volatility. "'The United States is closer than ever before to being a single natural gas market with congestion limited to a few markets for a few periods during the year,'" said the Commission's "State of the Markets Report 2009," as quoted by Costello.

Given the changes in the market, utilities and regulators need to reevaluate hedging policies, Costello said.

"Such review is especially useful in times like these, with new natural gas discoveries and drilling techniques that may provide ample gas supplies, with more stable prices, at least for several years," he said. "Until now, regulators have penalized utilities only infrequently for hedging practices that, in retrospect, were suboptimal and led to large losses that were passed on to customers. Utility and regulatory practices that might have sufficed for the past will not serve the public interest today."

©Copyright 2011 Intelligence Press Inc. All rights reserved. The preceding news report may not be republished or redistributed, in whole or in part, in any form, without prior written consent of Intelligence Press, Inc.

ISSN © 2577-9877 | ISSN © 1532-1231
Comments powered by Disqus