Hurricanes and Hedging - Price Risk Management in Action

September 2010

• Commodity price risk management costs money and raises questions. How likely is it that things will go wrong, and how bad will it be if they do?
• The annual hurricane season is one phenomenon that can be used to illustrate price risk management in action. Data for the 2005 to 2010 seasons show that a buyer who hedged every year over the 6 years would, on average, have paid less for their September to October gas purchases.
• Hedging usually involves paying a small, known premium time after time in order to avoid the potentially large impact of a relatively rare, but unpredictable, event.

One of the philosophies that Aegent stresses while helping clients with commodity price risk management, is that risk management costs money. Therefore, do only as much of it as you need to do.

This approach raises some more questions: how likely is it that things will go wrong, and how bad will it be if they do? How much of a 'premium' am I paying for the insurance against this outcome?

The annual hurricane season is one phenomenon that we can use to help illustrate some of these concepts in action. The hurricane season officially runs from June 1 to November 30 each year. In the spring each year, various expert forecasts are issued that assess the threat for the coming year. Will it be more active than normal? How many damaging storms are expected? How many storms will make landfall? These forecasts are based on sophisticated models, but they are not perfect and in fact, they are often wrong. So there is some uncertainty about how severe the season will actually be, and what impact it will have, if any, on natural gas production and gas prices.

The most intense period of storms usually seems to fall in September and October. Gas buyers who are concerned about a potential rise in gas prices during this period can hedge their risk by buying forward their gas for that period, and locking in a price. Buyers who are sanguine about the risk may choose just to buy on the spot market through September and October and pay the going price.

We can compare these two approaches over the last few years. If we can lock in our price in advance, or just pay the spot price, which approach will produce the lowest price? Is one strategy always the best strategy?

The comparison shows that usually a buyer pays a lower price by simply ignoring the forward market and paying the spot price. However, when the storm impact is significant, a significant rise in prices occurs. Depending on the buyer's ability to absorb higher prices, paying a small premium price on average year after year in order to have price certainty may be better than being exposed to a big impact in the odd year when things go very wrong.

We looked at prices for the September to October period at Henry Hub for each of the years from 2005 to 2010. A buyer could use the NYMEX to lock in a Henry Hub price for September and October in advance, or could just pay the spot price each day in September and October. Someone who chooses to hedge could buy on any day before September 1, so we simply averaged each day's value of the 2-month Sept-Oct NYMEX strip from April 1 to the end of August (when the September contract settles).

The table below shows the average price a hedger might have paid each year, versus the average price an unhedged buyer would have paid.

Average Futures vs Spot Prices for Sept-Oct Gas at Henry Hub

	USD/MMBtu
	Futures Price	Spot Price
2005	7.66	12.73	66%
2006	7.26	5.39	-26%
2007	7.42	6.44	-13%
2008	11.04	7.14	-35%
2009	4.02	3.51	-13%
2010	4.56	3.77	-17%
Average	7.48	7.04	-6%

The table shows that of the 6 years examined, the unhedged buyer would have paid less. Only in 2005, the year we saw Hurricanes Rita and Katrina, did the actual price impact of storm damage result in prices higher than the forward market had anticipated. In fact, spot prices in 2005 ended up 66% higher than the average futures price for the same period.

Someone who hedged every year would, on average, have paid about a 6% premium over the 6 years.

These figures illustrate the important concepts that energy buyers need to keep top of mind in their risk management decisions: hedging isn't about a pricing strategy that will always produce a lower price. Hedging usually involves paying a small, known premium time after time in order to avoid the potentially large impact of a relatively rare, but unpredictable, event. That's what insurance is all about.

Whether or not a buyer needs the insurance is a good question to ask, but to start to answer it, one needs to understand the cost of the insurance and have some sense of the size and probability of the risk being insured against.

Hurricanes and Natural Gas Prices: The Link Read more »

Buying to Control Price Risk Read more »