How To Hedge Natural Gas
Electric Companies Using The Short Hedge
For many retail electric companies you will find that when they are selling you an electricity rate that they actually hedge that rate by buying and hedging natural gas. Many of the power plants in Texas, for instance, have power generation plants that generate using natural gas. When electric companies buy electricity they are actually buying natural gas futures in a large part and hedging their futures contracts to protect themselves against adverse risk.
Short Hedges And Electric Rates
A common way short hedges are used is after an energy company buys an amount of natural gas futures they have an investment in that energy as inventory. They don’t actually physically have it in their own warehouse but it is in the pipes travelling from well head to well head and into the power generation plants that will be producing the electricity.
Short hedges are one of the most common forms of commercial hedging practices. The short hedge is also known as the seller’s hedge. The energy companies are protecting the inventory value of the futures contract at the time they bought it so that when they fashion the electric rate they can guarantee it to the customer at that price for a specified amount of time regardless of change in supply levels or price fluctuations. Locking in the inventory value is necessary otherwise the price quote would go up and down all day and would not be the same quote you were originally given.
When using a short hedge a general decline in prices generates profits in the futures market, which are offset by decline in the value of the physical inventory. The opposite applies when prices rise.
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