Risk Mgmt & Hedging Strategies In Natural Gas Industry

RISK MANAGEMENT AND HEDGING STRATEGIES IN NATURAL GAS INDUSTRY

1

INTR OD UCTION Natural gas is made up principally of a chemical called methane, a simple, compound that have a carbon atom surrounded by means of four hydrogen atoms. Natural gas provides one-fifth of all the energy used in the world. It is especially important in homes, where it provides nearly half of all the energy used for cooking, heating, and for fueling other types of home appliances. 2

USES OF NA TURA L G AS Natural gas is adaptable source of energy, which can be used by different sectors. Heating and electricity generation have been the main conventional uses. Increasing environmental concerns may show the way to a greater use of natural gas in transportation.

Residential users 

Residential applications are the most ordinarily known use of natural gas. It can be used for cooking, washing and drying, water warming, heating and air conditioning.

Commercial users 

Main commercial users of natural gas are food service providers, hotels, healthcare facilities or office buildings. Commercial applications comprise cooling (space conditioning and refrigeration), cooking or heating. 3

Power Generation 

Electric utilities and independent power producers are more and more using natural gas to provide energy for their power plants. In general, gas fuelled power plants have lower capital costs, are built faster, work more expeditiously. Technological improvements in design, efficiency and operation of combined cycle gas turbines and co-generation processes are privileging the use of natural gas in power generation.

Natural Gas Vehicles (NGVs) 

NGVs are natural gas powered vehicles. Natural gas can be utilised as a motor vehicle fuel as compressed natural gas (CNG). Cars using natural gas are estimated to emit 20% less greenhouse gases than gasoline or diesel cars. Natural gas in vehicles is inexpensive and convenient. 4

NA TURAL G AS MARKET In natural gas market gas is traded as a commodity, separate from transportation services, in the form of gas contracts. Although these contracts have numerous dimensions, they are distinguished primarily by the purpose of the transaction, whether for physical delivery of gas or for management of price risk. Physical Gas Market Financial Gas Market

5

FORMS O F N ATUR AL G AS Liquefied Natural Gas (LNG) LNG is natural gas brought down to a liquid state by cooling it to -161°C. Once liquefied, the natural gas is more compact occupying 1/600th of its gaseous volume. Natural gas is liquefied since in gaseous form, it is extremely voluminous and cannot be transported to long distances as gas field are far from the user market. Liquefied form eliminates the need for more room for gas transportation.

Piped Natural Gas This is one of the classifications of natural gas use where natural gas is utilized for domestic, commercial and institutional purposes.

Compressed Natural Gas (CNG) CNG is a replacement for gasoline (petrol) or diesel fuel. It is regarded to be an environmentally "clean" alternative to those fuels. It is made by compressing purified natural gas, and is typically stored and distributed in hard containers.

6

PURPOS E OF THE S TUD Y Energy industry is not like other industries. No other industry bestows such power on its producers. The natural gas industry is marked by a very high degree of price volatility. Through the use of derivatives products it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. The emergence of the market for derivative products can be traced back to the willingness of risk adverse entities to guard themselves against uncertainties arising out of fluctuations in asset price. The main purpose of this study is to provide risk management and hedging strategies to the natural

7

OB JEC TIVE O F TH E STU DY Understand the working of derivative contracts To analyze factors constraining the development of natural gas market Study of the risk matrix in natural gas industry Study of natural gas contracts. 8

LITER ATU RE R EV IE W Over the study of different research papers, it has been found that every paper has different aspect to work out, as the papers are written on problems faced by importers, refiners, producers due to price volatility. The lot of study had been done in the recent years; Companies are doing lot of research on the upcoming natural gas markets. The research paper on which I have worked to understand the whole process of hedging is ”Choices Among Alternative Risk Management Strategies: Evidence from the Natural Gas Industry” authors Christopher C. Géczy, Bernadette A. Minton, and Catherine Schrand describe the complementarities of a variety of risk management strategies that firms can use to reduce price risk exposure. The particular reference to the book Trading Natural Gas: Cash, Futures, Options and Swaps by Fletcher J. Sturm is imperative because it was helpful for the understanding of the subject. The book by Fusaro, Energy risk management;

9

RES EAR CH METH OD OL OGY Project is entirely based on the secondary data and information available. The collection of secondary data was via data available on the internet, international journals & magazines, international research papers, websites of the leading exchanges. After organizing and presenting the data, the research then has to proceed towards conclusion by logical inferences. The raw data is then analyzed: VI. By bringing raw data to measured data VII. Summarizing the data. VIII.Applying analytical methods to manipulate the data so that their interrelationship and quantitative meaning becomes evident. 10

NA TURAL G AS: G LOBAL PR OS PEC TIV E Gas markets are poised for rapid growth. Energy demand is speedily increasing and, spurred by environmental considerations, natural gas has become the quickest growing segment of the energy market. World Natural Gas Production (2007-08): 2940 BCM World Natural Gas Consumption (2007-08): 2921.9 BCM (World natural gas consumption rose by 3.1% in 11 2007)

NA TURAL G AS IN IND IA: A N OVER VIEW Gas occupies about 8.5% of the total energy basket of the country. Presently, fertilizers and power sectors remain to be major consumers of natural gas at 29% and 40% respectively. At present, there is an acute shortage of gas in the country. As against the current estimated demand of about 150 MMSCMD, the availability is around 96 MMSCMD. 12

RISKS AND HED GING Risk is concept that refers a potential negative impact to an asset or some characteristics of value that may arise from some present process or future event. There are five general types of risk that are confronted by all Businesses:     

Market Risk Credit Risk Liquidity Risk Cash Flow Risk Basis Risk 13

NA TURAL G AS H ED GEING Energy markets are the most volatile commodity markets in the world due to dramatic changes in the physical markets which are in turn influenced by unpredictable weather patterns, political events and dramatic swings in supply-demand balances. These factors lead to tremendous price swings in short time periods. The deregulation and restructuring of the natural gas industry in many industrial and developing countries have led to the development of new markets that have altered the way the industry operates. Two major markets emerge as a result of deregulation: the natural gas market, which facilitates the trading of natural gas as a commodity, and the transportation market, which enables market participants to trade the transportation services necessary to ship natural gas through the pipeline system.

14

Gas is traded like any other commodity on such a marketplace. Once there is sufficient liquidity, spot markets for immediate and forward delivery emerge. In places with a liquid forward market, futures markets evolve to hedge exposure to price volatility. Price volatility modifies the role played by traditional flexible tools, such as storage, which is increasingly used to maximise profits rather than simply to manage volume. 15

FUTURES A futures contract represents a legal agreement between a party that opens a position on the futures market to buy or sell natural gas at commodity exchange. In April of 1990, the New York Mercantile Exchange (NYMEX) introduced and commenced trading a natural gas future contract with the Henry Hub in Louisiana as delivery location, and in august, 1995 the Kansas City Board of Trade (KCBoT) introduced and commenced trading a western natural gas futures contract with Waha hub in West Texas as delivery point. 16

SWAPS A swap is custom-tailored, individually managed transaction designed to manage financial risk, usually over a period of 1 to 12 years. Swaps can be carried on directly by two counter parties or through a third party such as bank or brokerage house. The writer of the swap, such as a bank or brokerage house, might elect to accept the risk itself or manage its own market exposure on an exchange. Transaction helps each party to handle exposure to natural gas spot prices. 17

OPT IONS An options contract basically works like an insurance policy. If a homeowner wishes to protect himself against a risk, he pays an up-front premium. If the risk occurs, he is recouped. If the risk doesn't take place, he is out nothing but his premium. The holder of an options contract has the right, but not the obligation, to exercise his option. The seller, or writer, of an options contract holds an obligation to perform if called upon to do so. There are two kinds of options: calls and puts. A call gives the holder the right, but not the obligation, to buy the underlying futures contract. Conversely, a put option gives the holder the right but not the obligation to sell the underlying futures contract. 18

FINDINGS A ND ANAL YSIS

DERIVATIVE INSTRUMENTS APPLICATION TO INDUSTRY

Natural gas prices are now largely influenced by the forces of supply and demand. Technical factors, such as pipeline capacity, as well as fundamental factors, such as industrial use, influence prices. Price risk and competition have also been driven all the way from producers to resellers to the retail level. Futures and options are used to address the needs and risks of six important groups: producers, gas processors, interstate pipeline companies, local distribution companies (or LDCs), marketers, and end-users. The futures market allows industry marketers to lock in a purchase price for gas they have committed to deliver, or to lock in a selling 19 price, including a profit margin, for gas they have committed to buy.

PRODUCERS Abnormal weather conditions Uneven price movement

GAS PROCESSORS AND REFINERS Gas processors can use natural gas and propane futures to hedge the price risk of processing gas to extract propane. Gas processors use “Frac” spread to lock in attractive processing margin.

20

INTERSTATE PIPELINES Interstate pipelines are subjected occasional to price risk. Pipeline may be in a position where an alternative fuel, such as oil, is less expensive, and the cost of gas transportation is a critical factor in influencing the competitiveness of the delivered price of gas.

END-USERS Protecting against sharp price spikes which results in shortages or delivery slowdowns. Fixing short-term fuel costs. Locking in an attractive spot price. 21 Hedging storage gas.

THE INVESTOR Investors trade with risk capital. They have no position in the underlying commodity and no desire for one, so they have no vested interest in whether the price moves up or down. Investors seek to profit by correctly anticipating price changes. The more often prices move significantly, the greater the number of potential profit opportunities for the investor. The natural gas futures market provides investors with many attractive opportunities. Demand for gas is highly seasonal, but the seasonal impact on pricing is unpredictable. Variables include the severity of the winter weather, inventory levels, producers' needs to generate cash to cover their expenses, unexpected changes in demand for gas-generated electricity, transportation prices and constraints, and the cost of natural gas versus the cost of other fuels. The last variable in particular can provide investors with numerous trading opportunities in the form of inter-market 22

CONC LUSION Natural gas is an attractive fuel: it burns cleanly, producing little pollution, and its reserves are abundant. Natural gas prices are now largely determined by the forces of supply and demand. Technical factors, such as pipeline capacity, as well as fundamental factors, such as industrial use, influence prices. Price risk and competition have also been driven all the way from producers to resellers to the retail level. The futures market allows industry marketers to lock in a purchase price for gas they have committed to deliver, or to lock in a selling price, including a profit margin, for gas 23 they have committed to buy.

The market is a liquid one, giving participants the ability to enter and exit positions readily without disrupting prices in the broader market. Without futures, market participants must accept fixedprice contracts, which can prove disadvantageous. The futures planning.

market

provides

flexibility

in

forward

This flexibility is further enhanced by the options market which provides participants with, among other things, the ability to set price floors or ceilings, hedging against adverse price movements while retaining the ability to 24 participate in favorable ones.

THANK YOU

25

Q AND A

26