Price risk is the possibility that a commodity price change will cause financial losses for the buyer or seller of a commodity such as natural gas or electricity. Due to the volatility in natural gas and electricity markets, price risk is substantial for market participants that fail to adequately hedge. Here's an example of natural gas price volatility:
And here's an example of electricity price volatility:
Buying or selling at a fixed price — This requires no financial instruments and is simply handled through pricing of the physical gas or electric sale. For instance, a marketer may agree to sell natural gas to a Texas end user at a specific physical location for one year at a price of $3.90/MMBtu. Because the price is fixed, the end user has no price risk for that year. While the marketer has no price risk on the sale side of the transaction, she may be open to extreme risk if she hasn’t locked in adequate gas supply at a specific price to cover the deal. She will also be subject to basis (locational) risk if the gas supply purchase delivery point is different than the point of sale to the end user.
Buying or selling futures — A future is an agreement to buy or sell a specific amount of gas or electricity at a specific location at a specified date and price. All futures are traded through a central exchange that also guarantees performance of counterparties. Gas prices in North America are often hedged by buying or selling NYMEX Henry Hub natural gas futures. Because of the integrated pipeline network, futures at Henry Hub (located in Louisiana) are commonly used to hedge risk. Other exchanges are used to hedge gas prices in Canada, Europe, and LNG prices in Asia. Most futures positions are not closed out by actual delivery but simply through buying or selling at a later date through the exchange. Many parties like to use futures since the exchange guarantees performance and transaction costs are low. However, if a party is using the futures position to guarantee a price at a location other than the actual delivery location, she is taking the risk that prices at her desired location will not track the futures price (basis risk) at the delivery location. There is also the risk that movement in physical prices may not exactly match movement in futures prices.
An example of using futures to hedge physical price risk:
Buying or selling options — An option is a right, but not an obligation, to purchase or sell a future at a specific price within a specific time frame. Options are used to create price ceilings and floors rather than an absolute price guarantee. Options are offered through financial exchanges and there are two types. A call option grants the buyer the right to purchase a future at a specific price while a put option grants the right to sell a future at a specific price. The cost of this right is called the option premium. For the buyer, the risk of the option is limited to the option premium since if the option price is not supported by the market (“in the money”), the buyer will simply allow the option to expire. The seller, however, has an unlimited risk unless she has hedged the risk in some other way. One advantage to an option is that it is lower cost than using futures.
Using over-the-counter (OTC) derivatives — Many market participants use OTC derivatives for financial risk management. These instruments, offered by financial services companies, banks, and some marketers mimic many of the features of the centralized futures/options market but at different locations and under different terms. An example of an OTC derivative would be a price ceiling at the California-Oregon Border (COB). In this example, a bank guarantees a marketer that he will never pay more than $65/MWh for round-the-clock power across the summer months. If the price exceeds $65, the bank will compensate him for the difference between the higher price and the $65 ceiling.
Purchasing price swaps — Another common OTC derivative is known as a price swap. Here someone holding an electric supply asset (either generation or a contract to buy electricity) or a gas supply asset (production or a contract to buy gas) subject to market price risk may "swap" the price risk to a financial services company and instead receive a fixed price. OTC derivatives can be extremely varied and the products offered can differ widely. Margins and transaction costs are often high since the financial services company will want to be compensated for taking on the price risk.
Using financial transmission rights (FTRs) — If a generator or a marketer must use a path that is sometimes congested to deliver power to a customer, the supplier is at risk for transmission congestion costs. These can quickly turn a profitable transaction into a loss. One way for the supplier to hedge this risk is to buy FTRs from the ISO. Each ISO has its own procedures for offering FTRs, but the general process is that financial rights associated with a specific path are auctioned periodically. The winner of the auction then has usage of that path for a guaranteed cost, regardless of congestion costs. The supplier builds this cost into his transaction pricing and is no longer exposed to this risk.