You've worked hard to ensure you've gotten the best price available for your natural gas baseload; what happens when usage spikes cause you to scramble to find needed supply and pay inflated prices? Smart businesses make sure they always have access to needed supply at a reasonable price.
If we've learned anything in recent years, it is that weather is becoming more and more unpredictable and uncontrollable. Unexpected temperature changes can lead to a jump in natural gas prices, and ultimately financial loss for businesses that rely heavily on natural gas. For these businesses, weather contingent options can be an effective tool in protecting against sudden, unexpected usage demand and increases in natural gas prices.
How does it work?
When buying weather contingent options the business specifies its requirements:
- Temperature: The minimum, maximum or average forecasted temperature that triggers the option.
- Volume: The quantity of MMBtu that can be purchased those days the temperature meets levels specified in the option.
- Term: The length of the weather contingent option contract.
- Location: The location where the temperature is tracked.
- Specified price: Fixed price or index-based at a specific gas hub location. For example, a business in Louisiana might select Henry Hub as its gas hub and use the published IFERC index price.
Example:Acme & Co. based in New Orleans, Louisiana knows that its natural gas usage goes up when temperatures go below 35 degrees. To ensure the company has the needed supply, it executes a weather contingent option at a minimum forecasted temperature of 35 degrees (as published by the National Weather Service for New Orleans International Airport) to purchase up to 10,000 MMBtu of natural gas at a $4.50 IFERC index price for Henry Hub.
A cold front comes into New Orleans and the forecasted minimum temperature for the next day is 31 degrees. Since the forecasted minimum temperature is lower than the 35 degrees specified in the option, Acme & Co. has the right but not the obligation to purchase 10,000 MMBtu of natural gas from its supplier at $4.50 the following day. Because the spot prices are higher than the $4.50 IFERC index price, the company decides to use its option. In fact, the spot price for the gas daily midpoint is recorded later at $9.50 and the company saves approximately $50,000.
($9.50 - $4.50) x 10,000 MMBtu = $50,000
Benefit of weather contingent options
Businesses such as utilities or retail aggregators have managed their swing usage by buying on the spot market or purchasing peak options. There are drawbacks to both these approaches for temperature related spikes in usage. During times of extremely high or low temperatures many businesses have increased usage and the increased demand drives up spot prices. Peak options are an effective way to plan for these times but weather contingent options are typically less than half the cost of peak options. Weather contingent options provide a new way for companies to control their energy costs, smooth out earnings and limit any financial loss from unexpected temperature swings.