One of our subscribers recently sent us an email asking for our thoughts on the following article from the Tallahassee Gazette, City of Tallahassee down $54.3 million in fuel hedging program.  Just reading the headline made it pretty easy to guess how the "Cliff Notes" version would read: City of Tallahassee is upside down on natural gas hedges because they bought futures or swaps when the natural gas forward curve was trading at a significantly higher level than today.  And as predicted, our guess was correct.

Time and time again we see hedging/risk programs, that begin with the best of intentions, go wrong.  Why is this?  It's often due to the lack of a sound hedging/risk management policy, a poor hedging strategy(s) or simply a lack of understanding of the the program itself. Which was the cause in this case?

As the article states, The city of Tallahassee until recent years had success in its natural-gas hedging strategy, beating the spot market by buying long-term contracts designed to keep electric rates steady.

But in 2009, the program saw a stunning reversal of fortune. The city was locked into natural-gas contracts with prices nearly double what they were on the New York Mercantile Exchange. The energy risk-management program went $77.5 million underwater.

In 2010, the city closed the price gap somewhat but still saw a loss of $50 million.

The losses canceled out gains made in the earlier years. The city now is down $54.3 million based on annual price averages from October 2002 to September 2010."

In conclusion, while it appears that perhaps the author of the article, and some/many of the Tallahassee's natural gas customers, are unhappy with the results, the hedging program is in fact performing as designed, that is, ensuring that the City's natural gas rates are stable, regardless of the direction of NYMEX natural gas prices.

That being said, in the future, it would be possible for Tallahassee and it's customers to have their cake and eat it too but, doing so would require them to hedge with natural gas options, as opposed to futures or swaps.  However, options require significant upfront premium costs, costs which Tallahassee may not be able to afford or pass along to their customers.

Based on the discussions that we regularly have with municipal utility companies, as well as many other public entities, regarding their hedging policies and strategies, it has become clear that in addition to have a formal hedging policy which includes pre-approved hedging strategies, most need to do a much better job explaining their hedging policies and strategies to their customers, including how said strategies will impact their rates in times of both higher and lower NYMEX prices.