Hedging Natural Gas Prices
Luke Miller
Assistant Professor of Finance
Office of Economic Analysis amp; Business Research
School of Business Administration
Fort Lewis College
Natural Gas Industry
U.S. natural gas markets have undergone a remarkable transformation in recent years. After decades of rigid regulation, the natural gas industry is now free to compete on the wholesale level and, in a growing number of states, at the retail level. The result has been a substantial increase in the production of natural gas, far-reaching changes in the structure of the industry, and the growth of a large and fluid market in natural gas futures and options to cope with pricing uncertainties (NYME, 2003).
Natural gas is sold as a commodity, much like pork bellies, corn, copper, and oil. The basic characteristic of a commodity is that it is essentially the same product no matter where it is located. Natural gas, after processing, fits this description. Commodity markets are inherently volatile, meaning the price of commodities can change often, and at times drastically − indeed natural gas is one of the most volatile commodities currently on the market.
Natural gas is an attractive fuel: it burns cleanly, produces little pollution, and has abundant reserves. The Energy Department's study puts recoverable reserves and resources of natural gas in the lower 48 states at 1,310 trillion cubic feet, more than a 69year supply at current production levels. Most of these reserves are recoverable at prices below $3.50 per 1,000 cubic feet.
The deregulation that began in 1978 has addressed two important factors that were inhibiting the growth of the industry: the lack of incentive to drill for new supplies, and the lack of reliable, readily accessible transportation. Additionally, the 1990 amendments to the Clean Air Act have led utilities and industries to use more natural gas in place of the high-sulfur boiler fuels that contribute to acid rain. The nation's rising demand for electricity has also increased the importance of natural gas. Utilities are responding by building or contracting for new combined-cycle and cogeneration facilities, most of which are fueled by natural gas.
Most U.S. gas demand is met by domestic production. About 15% of U.S. natural gas consumption was met by imports, virtually all arriving by pipeline from Canada. The low level of U.S. imports is typical of the natural gas markets worldwide. While nearly 50% of world oil production crosses a country's borders, only 16% of the world's gas production does so. Natural gas accounts for 25% of primary energy consumption in the United States. End-users are generally grouped as residential, commercial, industrial, and power generators; each has its own risk profile.
The residential and commercial groups have fairly stable baseload demands and large, variable heating demands. This heating demand is the main force that drives the natural gas market during the winter; approximately 43% of the natural gas consumed throughout the year is actually used in the four-month period of December through March. Over the short term, residential and commercial heating demand is weathersensitive, varying primarily in response to the severity of the winter temperatures.
Many manufacturers consume natural gas, both as a feedstock and as a fuel for their manufacturing process. Generally, there is no other fuel that can be used for these purposes, or else the potential substitutes are costly, so this portion of industrial demand is not sensitive to residual fuel oil prices. However, both processing demand and boiler fuel demand are sensitive to changing levels of industrial activity — especially in the glass, food, paper, chemical, petroleum refining, primary metals, fabricated metals, and machinery industries.
For most electric utilities, air conditioning use is the major variable in market demand for electricity, and more and more power producers depend upon gas to meet peak demand. Since electricity demand peaks in the summer in most of the country, consumption of gas by electric power producers is counter-seasonal, helping to some extent to smooth out the highly seasonal demand pattern set by residential and commercial heating users.
La Plata County and Natural Gas
La Plata County sits on one of the largest natural gas reserves in the country. As such, the natural gas industry in La Plata County provides a substantial amount of tax revenue, providing the local community with many amenities that would not be possible otherwise (Walker and Sonora, 2005). Consider that:
• Direct spending by the natural gas industry in La Plata County for the year 2003 was approximately $215.7 million.
• Each dollar spent by the natural gas industry in La Plata County generates approximately $1.43 in additional sales (or output), or an additional $308.4 million dollars spent on productivity in La Plata County in 2003. This represents over 22% of the total personal income (or output) of La Plata County.
• Direct earnings spent in La Plata County increased by $42.6 million in 2003 because of natural gas operations. Total household earnings that can be attributed to the natural gas industry in La Plata County in 2003 equaled $78.5 million.
• Direct employment by the natural gas industry in 2003 was about 305 jobs which generates an additional 623 related jobs in La Plata County. This is approximately 4.2% of the total employment in the County.
• In 2003 the natural gas industry paid average salary was approximately $84,000, as compared with the average annual wage in La Plata County in 2003 of over $28,000.
• In 2003/2004 the natural gas industry accounted for about 48%/62% of all La Plata tax revenues, if natural gas prices continue, this sha
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