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Example 2 - Electricity Producer Fears a Price Decline Introduction Example 1 - Crude Oil Producer's Short Hedge Example 2 - Electricity Producer Fears a Price Decline Example 3 - Petroleum Marketer's Long Hedge, Rising and Falling Markets Strip Trades Spread Trades In this example, an independent power production company is at risk that falling prices will reduce profitability. It stabilizes cash flow by instituting a managed short hedging strategy on the electricity futures market. On February 1, the bulk power sales manager at a southeastern utility projects that he will have excess generation for the second quarter and notices attractive prices in the futures market for the April, May, and June contracts. The manager arranges to deliver this excess power at the prevailing market price in April, May, and June. However, he wants to capture the market prices now, rather than be exposed to the risk of lower prices in the spot markets. The action the utility takes to protect the company from this risk is to sell Entergy electricity futures contracts for those months. In the futures market, the producer sells 10 futures contracts for each of three months, April, May, and June at $23 per megawatthour (Mwh), $23.50, and $24, respectively. Assuming a perfect hedge, the futures sales realize $169,280 for the April contracts (10 contracts x 736 Mwh per contract x $23 per Mwh = $169,280), $172,960 for May contracts (10 x 736 x $23.50); and $176,640 for June contracts (10 x 736 x $24), for a total of $518,880. On March 29, the utility arranges to deliver 7,360 Mwh of April pre-scheduled power in the cash market, the equivalent of 10 contracts, at the current price which has fallen to $22 per Mwh, and receives $161,920. That is $7,360 less than budgeted when prices were anticipated at $23 per Mwh. Simultaneously, the producer buys back the April futures contracts to offset the obligations in the futures market. This also relieves it of the delivery obligation through the Exchange. The April contracts, originally sold for $23 ($169,280), are now valued at $22 per Mwh, or $161,920. This yields a gain in the futures market of $7,360. Therefore: The cash market sale of: $161,920 (7,360 x $22/Mwh) plus A futures gain of: $ 7,360 equals A net amount of: $169,280, or $23 per Mwh, the budgeted sum for April. As cash prices continue to be soft for the second quarter, the hedge looks like this: What happens to the power production company’s hedge if prices rise instead of fall? In that case, assume the cash market rises to $24, $24.50, and $25. The power producer realizes $176,640 on the cash sale of 7,360 Mwh for April, but sold futures at $23 in February, and now must buy them back at the higher price, $24, if it does not want to stand for delivery through the Exchange. The 10 contracts are valued at $176,640 which is what the company must pay to buy them back, incurring a $7,360 loss on the futures transaction. Therefore: The cash market sale of: $176,640 (7,360 x 24/Mwh) minus A futures loss of: $7,360 equals A net amount of: $169,280, or $23 per Mwh, the budgeted sum for April. As cash prices continue to be firm for the second quarter, the hedge looks like this: The average price of $23.50 per Mwh represents an opportunity cost of $1 per Mwh because cash market prices averaged $24.50 during the period of the hedge. The producer is comfortable with this because it is within the tolerance for risk that the risk management committee set at the time the positions were opened. Managing a hedge strategy is an evolving process. While hedges serve to stabilize prices, risk management targets can be reevaluated in future periods as market and financial circumstances change. Source: