Homework for EN 553.753

Homework #1: Hedging a Fixed Exposure using Futures

15 points. Due Wednesday February 13.

Suppose you work for a company that owns a plant that burns natural gas and produces steam and electricity for sale at a fixed contracted price. Although steam sales are your main business, the plant also produces a constant level of 44 MW of electrical power at all times. In other words, power production and gas consumption do not fluctuate as a result of changes in energy prices. (This is not typical for generating plants, but makes the problem easier.)

Your 44 MW (mega-watt) plant has a heat rate of 10 MMBtu per MWh, with a variable operations and maintenance (VOM) cost of \$4.00 per MWh. This means that the plant will consume 10 MMBtu of gas to produce one MWh (mega-watt-hour, which is MW integrated over time) of power. It also means that there is an additional cost of \$4 for each MWh produced.

Your steam contract nets you \$250,000 per month, and your power sales are for \$40.00 per MWh. Your fixed costs are \$200,000 per month.  You purchase all of your gas from a supplier, with whom your price is equal to the daily Chicago Citygate price quoted by Platts Gas Daily.

Your internal risk controls allow you to trade gas contracts on the ICE. However,  your  policy mandates that you use “flow contracts” (2,500 MMBtu/day per contract) rather than “ICE lots” (2,500 MMBtu per contract for the whole month).  Product descriptions may  be found at https://www.theice.com/products/Futures -Options/Energy, and end-of- day settlements at https://www.theice.com/marketdata/reports/142. You will need to gather information from these sites (click on the links to go there).

Please use settlement prices from February 6, 2019 for all of your calculations.

Your job is to figure out a hedging strategy that insulates you from price risk in July 2019 and in January 2020. (In reality you should consider all months, but there is little point in having you do the calculation dozens of times.)

Please indicate which contracts you would buy or sell, how many, and why. How much  of the gas price uncertainty are you able to hedge in this way? Would you buy index swaps? If so, when?

Please also indicate your price to generate each MWh of power in each month, and use that to estimate your cash flows for each month. Show your calculation and explain it. You don’t need to be verbose, but you should be clear and informative.

Homework                       §c 2019 Gary L. Schultz                           Page 2