Price Risk a Key Element in Balancing Natural Gas Supply

October 2011

• What doesn't get discussed often in organizations is the price risk associated with the annual balancing of its account with the distributor. The variability of weather creates the need to dispose of purchased natural gas that is not required, or the need to buy additional natural gas should the organization consume more gas than expected.
• The price of natural gas usually has changed over the course of the year, so the sale or purchase of balancing gas can have a budget impact - it is a volume difference that may not have been planned for, and it incorporates a price difference that may not have been planned for.
• To avoid the price risk associated with having to sell or buy the entire balancing volume at the end of the year, a prudent approach is to sell or buy smaller volumes throughout the year.

For natural gas consuming organizations, there is often conversation about the price risk associated with the price of natural gas. Having too much of the organization's gas supply exposed to fluctuating market prices can adversely impact an organization's ability to maintain gas costs within a budget. Developing an effective hedging strategy to manage budget risk is a key conversation that many organizations have. What doesn't get discussed as often is the price risk associated with the disposal of purchased natural gas that is not needed, or the purchase of additional natural gas should the organization consume more gas than had been projected.

For example, a firm may expect to use 365,000 gigajoules (GJ) of gas over the upcoming year and will provide a forecast to the natural gas distribution company. In response, the distributor will ask that the consuming company deliver 1,000 GJ per day for 365 days. The table below shows how the company expected to consume gas and how much gas they were expected to deliver each month.

To avoid the risk of fluctuating prices impacting budget certainty the supply of gas for the year was purchased at an average price of $6.00/GJ. If at the end of the year only 350,000 GJ of natural gas were consumed, then the company delivered 15,000 GJ of gas to the distributor that were in excess of requirements. This excess gas needs to be disposed of to balance the account. The need to dispose of this natural gas is where the price risk exists.

The price of natural gas likley has changed over the course of the year, so the sale of the gas will create either a financial gain or a loss. For example, if the market price at the time of the sale of the excess has declined to $4.34/GJ, the 15,000 GJ of gas will be sold at a price $1.66/GJ less than was paid. The hedge allowed the organization to meet their budget objective, but the sale of the natural gas at a loss reflects the price risk associated with the hedge.

Many consumers fixate on the unpleasantness of selling excess gas at a price lower that the cost of acquisition. However, having gas to sell means that gas costs will be lower than budgeted for, and that is a good thing. Nevertheless, it is important to get the most value possible for balancing gas to be sold, or the lowest price possible for incremental supply if it is required.

For this consumer, the difference between the actual and expected consumption arose during the winter months when consumption was lower than expected. Since summer consumption is low, any imbalance that exists at the end of the heating season will likely persist at the end of the natural gas year, unless the consumer takes action to mitigate it. Without absolute knowledge of future prices, it is impossible to be certain when the best price will be available for selling this gas.

To avoid the risk associated with having to sell the entire 15,000 GJ at the end of the year, a prudent approach would be to sell smaller volumes throughout the year. As shown in the table below, the average market price from November 2009 to November 2010 was $0.96/GJ below the purchase price of $6.00/GJ. While the natural gas was still sold at a loss, the risk of selling at the lowest price of the year can be avoided by selling smaller volumes throughout the year.

In this example, we see an organization that is selling gas in a market with declining prices. This represents only one of many scenarios that occur when balancing natural gas supply. However, in almost all situations, the difference between forecasted and actual consumption creates the need to either purchase or sell natural gas.

The volatile nature of natural gas prices and the uncertainty around forecasting future prices can lead to a speculative approach to buying and selling natural gas. What one paid for the excess gas is of no value in the decision about how to sell it, since generally it must be sold. The only question is whether the value that will be realized will be higher in the future than it is now. Ignoring gas imbalances until the contract end date is looming simply means the consumer has no flexibility in executing the transaction. The prudent approach is to manage proactively, and chip way at any imbalance in a series of smaller transactions.

A clearly developed and communicated strategy of prudent natural gas purchasing will help ensure the organization does not drift from core buying principles.

Forecasting Gas Consumption: What to Do about the Weather Read more »

Buying to Control Price Risk Read more »