SoCal Edison Buys Options on 740 Bcf To Hedge Power Purchases

Price volatility in the California power market prompted Southern California Edison to take the very unusual hedging approach of buying over-the-counter options on 740 Bcf of natural gas earlier this month. Although the huge deal is not likely to be replicated, Edison officials say the concept is spreading with competition in the retail power market.

California regulators had earlier given Edison permission to take this risk management route. Edison, like other California utilities, is barred from using the power futures market because by law it has to buy all of its power from the Power Exchange for the next four years. If for some reason Edison could not get out of a Nymex futures position, it may have to take delivery to the California-Oregon Border or Palo Verde. But Edison's John Butler, manager of capital markets, said the utility probably wouldn't use Nymex anyway because volume is still too low on its western power futures contracts.

The terms and conditions of Edison's gas options deal, which was put together by Houston-based Coral Financial Products and Services, were filed earlier this month with the California Public Utilities Commission. They are being kept confidential for competitive reasons.

Butler would not say how long the options are good for, although he did indicate it was for a multi-year period.

"We're required to buy all of our power out of the state PX, and the problem is that price is subject to market fluctuations, so the intent of this program is to try to put a cap on the highest price we would have to pay for electricity," Butler said. "It is not a perfect cap because these are natural gas options and not options on electricity itself. But for a portion of our electric load we are protected.

"These options are exercised in cash, so if it turns out gas prices are high, which would be likely to drive up electricity prices, then rather than receive gas for exercising the options, we receive cash. That helps to offset the cost of having to buy higher priced power out of the PX. It's an insurance policy basically."

Butler indicated that this type of hedge by an electric utility is still somewhat new. Longer term, he said it is "entirely possible" for use of gas options to spread to other states as electricity markets open up and regulation changes. In places where there's an abundance of gas-fired generation, the gas market can offer a great deal of flexibility to power purchasers, he noted.

The options are not based on any particular supply area; they are linked to a published natural gas price index. The Edison deal involves what Coral calls an "innovative type of natural gas option," specifically to mitigate against price spikes in the PX.

"...Edison faced a completely new type of risk with a potentially high, yet difficult-to-predict, exposure," said Lee Barba, Coral Financial's CEO. "Numerous factors could drive the price of wholesale electricity, and the complexity of the structuring came in analyzing and modeling the potential risk.

"We then used our market knowledge to develop a viable hedge portfolio and execution strategy which successfully assembled the required quantity of instruments in an efficient and orderly program."

Barba noted that similar risks will arise in other states such as New York and Pennsylvania, but different risk management approaches will have to be employed in each situation.

"There will not be a cookie cutter solution...for other utility companies," he said.

Coral Financial Products and Services is a unit of North American energy marketer, Coral Energy LP, also based in Houston.

Richard Nemec, Los Angeles

©Copyright 1998 Intelligence Press, Inc. All rights reserved. The preceding news report may not be republished or redistributed in whole or in part without prior written consent of Intelligence Press, Inc.