A Primer on Hedging Natural Gas Costs - Part I

In industries that consume large volumes of natural gas, such as manufacturing and processing, as well as companies that simply use large volumes of natural gas for heating, volatile natural gas prices can wreak havoc on the bottom line. If an organization chooses not to manage this exposure, it can often result in the organization significantly exceeding its budget, or worse, as many have experienced during recent surges in natural gas, especially in Europe.

Although there are many factors that affect natural gas prices, economic conditions, natural gas storage levels and weather, as well as the market's perception of these factors, are the primary factors that drive natural gas prices.

Most large natural gas consumers can mitigate their exposure to natural gas prices costs, as well as other energy costs, through hedging. Hedging allows market participants to manage their natural gas costs while reducing the potential impact of volatile and/or potentially rising natural gas prices.

Hedging reduces a company's exposure to natural gas price risk by shifting the risk to another party with an opposite risk profile, i.e., a natural gas producer, or to traders who are willing to accept the risk in exchange for potential profit opportunities. Natural gas hedging generally involves establishing a position in a financial instrument that is, ideally, very similar if not identical, to the company's exposure to the physical natural gas market. The physical market, also known as the cash or spot market, is the "market" where a company procures the actual natural gas that it consumes in its day-to-day operations.

Hedging "works" because the price for natural gas in the physical market and the price for natural gas in the financial market tends to have a strong correlation. While the relationship between physical and financial gas prices (known in the industry as the basis) isn't static, the risk of an adverse change in this relationship is most often significantly lower than the risk of not hedging at all.

Natural Gas Hedging vs. Speculating

It is crucial to remember that the purpose of hedging is to mitigate a company's exposure to a risk, in this case natural gas prices, thus stabilizing the end-user’s costs and profit margins. Hedging is not a means for a natural gas consumer to speculate on the price of natural gas. Speculating on natural gas prices, especially when veiled as hedging, all too often produces results which are less than desirable; most companies are better off doing nothing at all vs. taking speculative positions in the natural gas market.

Large gas consumers should employ hedging to reduce the probability that their costs, profit margins and cash flows will be affected by volatile and/or "high" natural gas prices. On the other hand, speculators are of the opposite mentality. Speculators "bet" on the direction of natural gas prices in hopes that they will be able to "buy low and sell high" or vice versa.

It is equally important to acknowledge the fact that if a company decides not to hedge its exposure to natural gas prices, it has effectively concluded one of two things:

  1. The company can pass on an increase in natural gas costs to its customers, without experiencing lower profit margins and/or cash flow issues; or

  2. The company is "confident" that natural gas prices are going to remain stable and/or decline and, it is comfortable paying a higher price, if in fact, prices increase significantly.

The primary instruments used to hedge natural gas are fixed forwards, swaps, futures, and options, which we will discuss at length in future posts, as each of these instruments deserve a thorough explanation. 

In summary, there are numerous ways an organization can hedge its exposure to natural gas prices, including futures, swaps, and options. By developing and implementing a natural gas hedging program, large natural gas consumers can not only mitigate their exposure to volatile natural gas prices, but they will also be able to accurately forecast their future natural gas costs and better manage their profit margins.

This article is continued in the follow up article A Primer on Hedging Natural Gas Costs - Part I.

If you are interested in practical, quantitative examples of natural gas hedging strategies, please see the following posts:

An Introduction to End-User Natural Gas Hedging - Part I - Futures

An Introduction to End-User Natural Gas Hedging - Part II - Swaps

An Introduction to End-User Natural Gas Hedging - Part III - Basis

An Introduction to End-User Natural Gas Hedging - Part IV - Call Options

An Introduction to End-User Natural Gas Hedging - Part V - Costless Collars

An Introduction to End-User Natural Gas Hedging - Part VI - Call Spreads