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Natural Gas Hedging.ppt
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Natural Gas Hedging: Benchmarking Natural Gas Hedging: Benchmarking
Price Protection StrategiesPrice Protection Strategies
BackgroundBackground
Natural gas is the cleanest burning fossil fuel producing less
emissions & pollutants than either in coal or oil
It is also the next best alternative to crude oil
Dependence of crude oil & growing emissions can be substituted by
Natural gas which is a cheaper & cleaner fuel
Energy security and fuel diversifications policies have also played an
important role in encouraging gas demand as a means of reducing
dependence on imported oil.
introductionintroductionEnergy markets operate in an environment exposed to a variety of risks
responsible for the high volatility of the prices of oil, natural gas, electricity
and freight rates.
The need to control this price volatility has prompted the development of
valuation and risk management methods for energy assets
Derivative contracts are incredibly powerful tools for managing expected
return and risk.
This report provides an In-depth analysis of the rationale of hedging in the
natural gas market.
Objective of the StudyObjective of the Study
Finding the perspective with which risk management is done in
the energy markets.
Types of derivatives instruments global markets have and their
benefits to the natural gas industry.
Study of Risk matrix in Natural Gas industry.
Study of Natural Gas Contracts
Purpose of the StudyPurpose of the Study
To acquaint knowledge with
Natural Gas Trade
Natural Gas Contracts
Hedging instruments
LITERATURE REVIEWLITERATURE REVIEW Referred :
Options, Futures, and other Derivatives by John.C.Hull
Natural Gas Trade by Pennwell Books
Energy Price Risk Management by Tom James
Websites Referred
ICE
International Energy Agency
Platts & Argus
Traders Log
NATURAL GAS CONTRACTSNATURAL GAS CONTRACTS
History Of Natural Gas Contracts
NG Sales and Purchase Agreements (SPAs) were developed from pipeline
gas contracts from early days of NG industry.
At that time, both seller and buyers needed long term commitments to
provide security to raise finance, often running into billion of dollars, for
their respective facilities.
The terms and conditions in NG SPAs include severe penalties for a
failure to perform including, for example, obligations for the buyers to
pay for an agreed volume of NG even if it is unable to take all the volume
(take or pay).
TYPES OF TYPES OF NATURAL GAS CONTRACTNATURAL GAS CONTRACT
Natural Gas
Contracts
Natural Gas
Contracts
Long TermLong Term
Short TermShort Term
Long Term Contracts
1. Fixed price, till the contract
lasts.
2. Future estimations of demand
and supply done.
3. Less risk.
4. With limited volume of
flexibility, it supports the
development of the natural gas
business.
Short Term
Contracts
1. More flexible contracts
2. Made on the basis of a single –
cargo or a number of cargoes
over a limited period of time
3. The price will either be fixed
when cargo is loaded or it may
be linked to an escalator
4. Risk of volatility and high
prices
Risk ManagementRisk Management Every business has Risk-Return tradeoff at its heart.
An opportunity to earn handsome returns comes with a risk
of heavy losses.
The Energy Industry and its associated markets experience a
lot of risk due to the volatility involved.
The businesses must learn to assess and manage this risk in
ways that allow them to exploit opportunities while limiting
their exposure to unpredictable factors in their operating
environment.
THE RISK MANAGEMENT THE RISK MANAGEMENT PROCESSPROCESS
A comprehensive risk measurement approach
A detailed structure of derivative position limits
Clear guidelines and other parameters used to govern risk
taken by officers of the organization
There should be a strong risk management information
system for
Controlling Risk
Monitoring Risk
Reporting Risk
Risk Matrix in Risk Matrix in Natural Gas IndustryNatural Gas Industry
HEDGINGHEDGING
Hedging is a powerful financial tool. It can be used a strategy to
enhance or insure against investments.
Hedging is a risk mitigating activity
Taking a position in futures market that is opposite to a position in
the physical market.
Why hedging?Why hedging?Financial and Commodity Derivatives are Financial instruments that have been traded in Global Markets for past 100 years
Hedging: Risk reducing strategies with aim to limit losses
or lock-in profits in bear and bull markets respectively
Speculation: Leveraged investments bearing
unlimited profits or losses.
Hedging Principles Hedging Principles ChecklistChecklist
Is there a Profit or Position to Protect?
Specific position to protection or general portfolio insurance?
Locking-in current levels or protecting against tail risk?
Are There Specific Risks to Protect Against?
Risks that market drifts lower or Gaps lower?
Macro inflection points: interest rates, FX.
Geo-political event risk
What Factors Affect a Hedging Strategy?
HEDGING INSTUMENTSHEDGING INSTUMENTSHedging instruments include
Interest Rate Swaps Equity Options
Interest Rate Futures Equity
Swaps
Credit Default Swaps
Credit Options Commodity Swaps
Commodity Futures
Commodity Options
FX Futures
FX Options
Interest Rate Risk
Credit Risk
Currency Risk
CommodityRisk
Equity Risk
HEDGING STRATEGIESHEDGING STRATEGIES
ForwardsForwards Forward contracts are based on physical delivery of the
underlying commodity during an agreed time period in the future,
either a full calendar month or a specified part of it.
They specify standard quantities and qualities, and are subject to
a mutually agreed set of terms and conditions in order to provide
a flexible trading instrument
Forward contracts involve a number of delivery risks for the
parties concerned that do not arise in the case of futures contracts.
Counter party default risk
futuresfutures It is an agreement between two parties, a buyer and seller, for
delivery of a particular quality and quantity of a commodity
at a specified time, place and price.
Uniqueness of these contract is that 98% of the positions are
squared off before expiry
These contracts are suitably preferred for risk mitigating
activity.
OptionsOptions Give the option holder the right, but not the obligation, to
buy (or sell) an underlying asset at a specified price during
an agreed period of time.
Two basic types of option contract
Call/Cap options, which give the holder the right to buy;
Put/Floor options, which give the holder the right to sell.
An options contract will only be exercised if the market
moves in favor of the holder.
OPTION COMBINATION OPTION COMBINATION STRATEGIESSTRATEGIES
Option spreads involve taking simultaneous opposing
positions at different exercise prices or strike prices.
Straddles involve selling call (cap) and selling put (floor) at
the same strike price in the same market.
Vertical Spread involve Selling (or buying) a lower priced
put (or call) option while buying (or selling) a higher priced
one is bullish; taken in reverse, the vertical will be bearish.
Butterfly strategy is a more complex options spread built
from options bought and sold at three different strike prices.
Say if the natural gas contract is trading at $4,
A long butterfly could be made by buying puts (or calls) at
$3.8 and $4.2 and
Selling twice as many puts (or calls) at $4.
The maximum profit comes if the contract is right at $4 at
expiration, and
The maximum loss occurs if the price moves past either
$3.8 or $4.2.
SwapsSwaps
A swap is a purely financial transaction that is designed to
transfer price risk.
A swap can be most simply defined as an agreement
between two parties to exchange, at some future point, one
product, either physical or financial, for another.
But, in derivative form swap is purely cash settled.
The attraction of swaps is three‐ fold.
First, they are purely financial transactions and can therefore
be traded without incurring the quality risks and other
delivery problems normally associated with physical oil
contracts.
Secondly, they offer the prospect of the “perfect hedge” since
they can be tailored exactly to meet the requirements of each
participant.
And, thirdly, and most importantly, they can be traded far
into the future since they are not constrained by the more
limited time‐horizons of existing futures or forward markets.
ENERGY SPREADSENERGY SPREADSSpark Spreads
The spark spread involves the simultaneous purchase and
sale of electricity and natural gas futures contracts.
This allows traders to take advantage of the generic
conversions of natural gas to power to help price the
forward electric power curve using natural gas-fired
generation operating efficiencies and prices.
By buying natural gas futures at a relatively low price and
selling electricity futures at a relatively high price, generator
is hedging his profit margin for physical sale.
ConclusionConclusion Price risk management tools such as derivative instruments
are used to manage price volatility in order to protect
company revenues and profits
The hedger uses derivatives to protect a physical position
or other financial exposure in the market from adverse
price moves which would reduce the value of the position.
The hedge position is established to buffer against day-to-
day market fluctuations in accordance with strategic
company objectives.