Managing Natural Gas Risks

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Managing Natural Gas Risks
By Jim Gleitman Yijun Du Lower Colorado River
Authority August 7, 2001
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Natural Gas Price Risk
Average Price 1994 1.88 1995 1.64 1996
2.58 1997 2.59 1998 2.11 1999 2.27
2000 3.88
Avg Volatility 65 vs. Stocks 22
Peak Volatility in December 2000 _at_ 140!!
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Types of Risks in the Energy Markets

• Price risk
• Volumetric risk
• Basis risk
• Credit risk
• Operational risk
• Legal risk

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Natural Gas Market Fundamentals
Key Indicators to Monitor

• US Lower 48 Gas Production
• Gas Exploration and Development Drilling
• Canadian Imports
• Core Industrial demand (longer term impact)
• Weather (heating and cooling, supply disruptions)
• AGA Storage Inventory

Secondary Indicators to Watch

• Nuclear Outage
• Crude and Fuel Oil Prices for Fuel Switching
• Electricity Prices affecting Gas Prices
• Pipeline constraints - basis changes

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Natural Gas Market Dynamics
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US Lower-48 Average Daily GasProduction Capacity
Projection
Historical
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Importance of Canadian Imports
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Baker Hughes U.S. Weekly Natural Gas Rig Count
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U.S. Natural Gas Consumption by Sector
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U.S. Natural Gas Consumption by Season Region
94 99 Average
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U.S. Natural Gas Storage Cycles
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What Happened in year 2000 and 00/01 Winter

• Core industrial demand at peak
• Gas demand from power production increased 2
  bcf/d during the summer months (June to Sep.)
• High crude and heating oil prices
• Natural gas supply flat/decline YOY
• End of October storage near record low _at_2.75 tcf
• Record cold during November and December created
  short squeeze

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Winter (Dec-Feb) 2001 US Average 31.65 deg F
1.35 deg lt normal (33) (Rank 25 in 105 years)
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November 2000 Temperature Avg 38.69 deg F,
3.8 deg lt Normal (42.5) (Rank 2 in 106 years)
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December 2000 Temperature Avg 28.93 Deg F,
4.47 deg lt Normal (33.4) (Rank 7 in 106 years)
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2001 YDT Weak Demand Improving Supply Allow
Storage Injections at Record Pace
Supply Response

• Record gas drilling Well completion
• Production capacity increases 1 to 1.5 bcf/day
• Canadian import increases 1 bcf/day
• LNG imports pick up slightly

Demand Loss

• Manufacturing recession cuts down industrial
  demand _at_
• 4 bcf/day
• Weak economy mild weather reduce electricity
• generation, 1 bcf/day
• Fuel switching in 01 1st half (1.5 bcf/day)
  provided needed relief

Storage Injection at Record

• Supply rebound and demand loss contributed to
  record
• injection _at_ 109 bcf per week since late April
  
• End of October level 3050 bcf or more

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January - June 2001 Temperature
Slightly Above Normal
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Declines in Industrial Production Gas-intensive
Manufacturing Sectors
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What is in Store for the Remaining 2001 and
Upcoming Winter

• Core industrial demand continues to be weak
• Winter will be close to normal overall
• Relative higher crude and heating oil prices will
  cause fuel switching to natural gas _at_ 1 bcf/d
• Natural gas supply increases 1 bcf/d YOY
• Start the winter with near record inventory
  around 3.1 tcf and end the winter around 1 tcf
• Natural gas price will be significantly less
  volatile for the upcoming winter
• Outlook for winter strip 2.5 to 4

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Weather Outlook September 2001 and Beyond
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2002 Demand Rebound Supply Growth Allow A
More Balanced Overall Gas Market
Supply Response

• U.S. production capacity grows at 0.8 to 1.2
  bcf/day
• Canadian import increases at 0.5 to 0.7 bcf/day
• LNG imports increase as facilities open up

Demand Rebound

• Demand rebound as economy recovers
• New gas-fired power plants continue to build at
• over 10,000 MW per year
• Fuel switching back to gas

Storage Levels at Normal

• End of 02 winter storage inventory 900 to 1000
  bcf
• End of 02 October level 2900 to 3000 bcf

Price Outlook for 2002 3.25, Range 2.5 to
4.5
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General Framework of Risk Management

• Identify corporate strategy earnings, cash flow,
  competitiveness, etc
• Determine risk profile risk exposures and risk
  tolerance
• Establish clear program goals objectives
• Develop hedging strategy. Decisions include
• Hedging ratio, timing, periods, tools, costs,
  and
• How basis risk, if any, will be handled.
• Establish appropriate controls support system

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What is Hedging

• Hedging involves combining two or more risky
  assets in order to achieve an overall lower risk
  profile when compared to buying any one asset
• Portfolio theory extends the hedging principal
  to its most general form

Example - Opposition Hedge A position in the
futures market equal and opposite to a position
at risk in the cash market. Therefore,
Net Benefit (cost) CASH gain or loss
on FUTURES
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Hedging Example
Storage (carrying-charge) hedge under contango
market
It is assumed that the geographic basis remains
the same. If the geographic basis changes, then
a basis hedge is required.
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Different End-user Hedging Strategies
MostRisky
MostConservative

• Similar to buying insurance
• Worst case fuel expense knownat outset
• Full downside participation

• No, or limited, cost
• Upside fuel expense limited (strike of call)
• Downside participation limited (strike of put)

• No upfront cost relative to price
• Lock in competitive spread
• Give up some upside for some downside
  participation

• Maximum benefit is upfront premium
• No upside protection
• No downside participation

• No upfront cost
• Fixed fuel expense
• Full protection from higher prices
• No downside participation

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Unhedged Price Probability Distribution
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Probability Density Function, Hedged 100 with
Call options
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Unhedged
Call
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Mkt Price 4.25 Floor No Cap
5.15 25h tile 3.70 75th tile 4.75
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Probability Density Function ()
10
8
6
4
2
0
1.40
2.30
3.25
4.20
5.10
6.05
7.00
7.95
8.90
9.80
10.75
11.70
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Probability Density Function, Hedged 100 with
Collars
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Probability Density Function, Hedged 100 with
Swaps
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Unhedged
Fixed-Price Swap
45
40
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Mkt Price 4.25 Floor 4.25 Cap
4.25 25h tile 4.25 75th tile
4.25
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Probability Density Function ()
25
20
15
10
5
0
1.35
2.40
3.40
5.50
6.55
7.55
8.60
9.65
4.25
10.70
11.70
12.75
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Probability Density Function of A Diversified
Portfolio, Hedged with 1/3 Calls, 1/3 Collars,
and 1/3 Swaps
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Optimal Hedging Ratio for Monthly Gas Purchase

July, 1999
Gas Price
100 Fix
2.29
Optimal Hedging Ratio 38
100 Floating
2.10
Efficient Frontier
Utility Function
Volatility
0
33 Cents
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Benefits of Risk Management

• Reduces price basis risk exposures
• May provide competitive advantage
• Facilitates planning/budgeting
• Enhances creditworthiness
• Assures price transparency

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The Power to Make A Difference.