Email This Author Comment On Article About The Author More Articles By This Author

Natural Gas has taken off on another of its not so infrequent excursions into the stratosphere of pricing. Depending on the commentator, prices are either going to revert to $3.50 or go to $10 in the next three hours. What does the energy consumer do now? Hedge – but learn from California. What can consumers do at these prices? They can buy long forwards or they can buy call options. I know – buy options? But then don’t I have to pay premiums? And if prices go down don’t I lose my money? Let’s examine all these points. Paying premium is the first. Yes, options cost up front money and, yes, if prices go down the premium is a non-recovered sunk cost. My response is: so what? Let’s examine the list of the potential results and you will see why I feel that way. If you buy forwards and prices go down, what happens? You have to pay margin. If the prices drop 25%, the margin will equal the price drop. If you are borrowing money to post margin the cost is the cost of money times the margin call. At 8% money, the 25% margin call mean that 2% of your energy bill is lost interest costs – so the potential premium loss is already reduced by the margin costs. Plus don’t forget, the margin call shows as debt on the 10Q. So the 25% margin call would reduce earnings much more than the option premium would – yes? If prices go up you are paying the option call price plus the premium but you are probably still competitive. Second, if you buy a forward and prices drop, what happens to your competitive position? Does paying 25% more for energy hurt your competitive position more than the sunk cost of the premium? I would expect that it would. Third, what happens if the economy slows down due to Iraq and prices drop? This is the California experience showing through. Forwards are a risky exposure when the potential for a price drop exists and demand is also uncertain. If your demand drops and the price drops, you could be faced with selling above market energy back to the market and taking a direct loss on what was supposed to be a “hedge”. A consumer hedge using a forward can only be a hedge if the consumption is guaranteed. Otherwise, you run the risk of having a purchase obligation without a corresponding use. So yes, options are expensive now but they may make more economic sense than a buying firm energy through a forward. That is Volatility Managers opinion.