Energy Hedging 101

E

energynewbie

Suppose you're on the board of company whose primary business is selling a deregulated energy product (nat gas, power, heating oil, propane, etc). As a board member you have to suggest a strategy as to how the company should "hedge" it's upcoming fixed price offering.

Your main challenge is that 3-6 months from today (May '07 - Aug '08 time frame) your competitors will most likely offer your potential customers a fixed price on product to be delivered from Oct '07 - Apr '08.

Assume that industry wide profits margins are generally too small to justify simply getting long call options and that the product is not storable and/or you don't own assets.

Generally speaking, what would you suggest and why?
 
If you don't have the resources to cover the cost of options and you want to be hedged you'd have to go out and lock in a price with futuress. That said, the costs of using futures could potentially be greater than using options alone if a the position does not go in your favor. That is, if you determine that you need to supply your customers with 10,000 dekatherms of gas a month and you go out and buy futes from NGK7 (May 07)-NGQ8 (Aug '08), you are thereby locking in a price for yourself for the commodity, regardless fo what the price does (ie if it goes down, you don't look too good). The issue is you are now going to pay the strip value (which settled last night at 8.123) regardless fo what the true price you pay is, so you either eat it or pass it along to the end users. Options would give you the upside protection if the price spikes while still giving you some downside opportuntiy as well, but they would be expensive for sure. Given current storage excesses industry-wide, it is widely anticipated that this market is going in the tank as soon as this cold snap lets up, so if I were you and you need to buy fuel I'd wait. If you already have contracts signed to buy the fuel from a producer and don't want to be exposed to downside risk I'd say do it all very soon...maybe even now. If I can help more just reply here...
 
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Quote from PJKIII:

If you don't have the resources to cover the cost of options and you want to be hedged you'd have to go out and lock in a price with futuress. That said, the costs of using futures could potentially be greater than using options alone if a the position does not go in your favor. That is, if you determine that you need to supply your customers with 10,000 dekatherms of gas a month and you go out and buy futes from NGK7 (May 07)-NGQ8 (Aug '08), you are thereby locking in a price for yourself for the commodity, regardless fo what the price does (ie if it goes down, you don't look too good). The issue is you are now going to pay the strip value (which settled last night at 8.123) regardless of what the true price you pay is, so you either eat it or pass it along to the end users. Options would give you the upside protection if the price spikes while still giving you some downside opportunity as well, but they would be expensive for sure. Given current storage excesses industry-wide, it is widely anticipated that this market is going in the tank as soon as this cold snap lets up, so if I were you and you need to buy fuel I'd wait. If you already have contracts signed to buy the fuel from a producer and don't want to be exposed to downside risk I'd say do it all very soon...maybe even now. If I can help more just reply here...
More...

I guess I should have stated it differently. Our customers would want to lock in their price sometime between May '07 and Aug '07 (which is when we market/sell for the following winter) for NG to be delivered Oct '07 - Apr '08. I understand the basics, am just trying to think outside of the box.

The company has enough capital to buy options but potential profit margins won't allow us to buy outright calls and be competitive with others selling a fixed price i.e. if the strip is 8.123 the most we would probably be able to sell it to our customer is 8.35 (assume no cost for transport, etc) so in this situation you obviously can't justify paying upwards of 1.00 for atm calls.

Company does not have any relevant positions on the book as of today.
 
you could sell puts below the market (out of the money). selling puts locks you into buying if the price drops but adds to the bottom line with the decay and stable or rising prices.

if you wanted to limit loss in the event of a major drop in price then you could sell put spreads.
 
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