Industrial Gas Hedging: Policy Limit, Collar, and Basis Risk
An industrial gas user consumes 2.4 million MMBtu annually. It sells 60% of output under fixed-price contracts that assume gas at $3.00/MMBtu; the remaining 40% passes gas cost through. The forward curve is $2.85/MMBtu flat. The risk committee has approved hedging up to 70% of the fixed-price exposure. The company has already swapped 600,000 MMBtu at $2.85. A bank offers a zero-cost collar on 500,000 MMBtu with a $3.40 cap and $2.50 floor, or a $3.20 cap for $0.12/MMBtu. Local citygate basis has averaged $0.30 over Henry Hub but has ranged from $0.10 to $0.85 during cold snaps.
1. Calculate fixed-price exposure, current hedge ratio, and maximum additional hedge under the 70% policy.
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Fixed-price exposure = 60% × 2.4 million = 1.44 million MMBtu. Current hedge ratio = 600,000 / 1.44 million = 41.7%. The 70% policy limit = 70% × 1.44 million = 1.008 million MMBtu. Maximum additional hedge = 1.008 million - 600,000 = 408,000 MMBtu. The offered 500,000 MMBtu collar would take total hedges to 1.1 million MMBtu, or 76.4% of fixed-price exposure, breaching policy by 92,000 MMBtu. The company should resize the collar to 400,000 MMBtu or seek committee approval for the higher ratio. This is a policy and governance issue before it is a market view. The passthrough 40% should not be counted as fixed-price exposure for this limit.
2. Compare the swap-plus-collar and swap-plus-cap outcomes at Henry Hub $2.20, $3.40, and $4.50, assuming a $0.30 basis. Use a 400,000 MMBtu collar sized to policy.
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Swap layer: 600,000 × ($2.85 + $0.30) = $1.89 million. Unhedged fixed exposure: 440,000 MMBtu. Collar effective gas cost = min(max(P, $2.50), $3.40) + $0.30. At P = $2.20: collar $2.80, unhedged $2.50; total = $1.89 + $1.12 + $1.10 = $4.11 million, or $2.854/MMBtu. At P = $3.40: collar $3.70, unhedged $3.70; total = $1.89 + $1.48 + $1.628 = $4.998 million, or $3.471/MMBtu. At P = $4.50: collar $3.70, unhedged $4.80; total = $1.89 + $1.48 + $2.112 = $5.482 million, or $3.807/MMBtu. Cap-only at $3.20 and $0.12 premium: at P = $2.20 total about $4.038 million; at $3.40 about $5.126 million; at $4.50 about $6.49 million. The collar is cheaper at high prices but loses the downside benefit below the floor.
3. Why may the zero-cost collar be inappropriate despite no premium? Address volume, basis, liquidity, and accounting.
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A zero-cost collar is not free; it sells a floor. If gas falls to $2.20, the company pays the $0.30 floor difference on 400,000 MMBtu, about $120,000, reducing competitiveness against rivals without hedges. The original 500,000 MMBtu size also breaches the 70% policy. Basis is unhedged: if citygate basis widens from $0.30 to $0.85, the extra $0.55 on 1.44 million MMBtu is about $792,000, far larger than the collar's apparent premium saving. A collar can require collateral if mark-to-market moves against the company, while a cap premium is paid upfront. Accounting may require mark-to-market treatment and hedge documentation. The company should layer caps and collars, size to policy, stress-test basis, and monitor counterparty credit rather than treating zero premium as zero cost.