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Natural Gas Primer
Natural Gas Primer Glossary of
Basic Terms
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Columbus, Ohio, 43215
phone 614.469.8000
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Generally, the supplier assumes the responsibility to manage the delivery of the end-user's gas supplies. This commonly includes procurement of the commodity, nominating, delivery, and other requirements imposed by the local distribution company ("LDC"), such as maintaining the end-user's storage, keeping the end-user's bank balanced within tolerance, and complying with flow requirements during peak day and emergency conditions. Further, end-users with alternative fuel capabilities that require coordination with natural gas supplies may wish to bring this need to the attention of the selected supplier. Moreover, for end-users with firm transmission to the city-gate, the supplier is also commonly responsible to deliver the required daily volumes during peak day conditions, such as Columbia Gas of Ohio's Operational Flow Order ("OFO") and Operational Matching Order ("OMO") requirements.Suppliers should, and typically do, perform these types of functions and services to add value to the relationship with the customer.

End-users may also wish to protect themselves by writing into the contract with their selected supplier, that the supplier will indemnify the end-user against all penalties incurred as a result of the supplier's failure to perform the assumed responsibilities. For example, these may include penalties incurred as a result of the supplier's: failure to deliver sufficient gas to cover the end-user's needs resulting in the purchase of shortfall gas from the LDC; failure to maintain the end-user's storage or balancing bank within the agreed upon tolerance resulting in penalties from the LDC; and failure to deliver gas to the end-user's local market area during peak day conditions, such as Columbia Gas of Ohio's OFOs and OMOs. These requirements may be obtained by contacting the LDC.


Properly utilized risk management strategies can add predictability to energy buying costs and lower overall energy costs. Risk management can also help increase profits and stabilize cash flow for more effective long-term planning. This writing is intended only to familiarize the reader with some of the options available for risk management and some of the commonly used instruments. Risk management starts with a candid assessment of risks and corporate needs, followed by the selection of appropriate risk management instruments. A variety of risk management instruments are available to manage volatility and limit exposure to swings in the energy marketplace. Some of the common instruments are discussed below, and are applicable to both the natural gas and electric industry. However, unlike the mature gas market, the emerging competitive electric market lacks the underlying transaction liquidity.

Financial Swaps - Price Exchanges
A swap is a financial agreement between parties to exchange periodic payments. This commonly involves a party making fixed payments and a second party making variable payments that float based on prevailing market prices. Swaps enable energy buyers and energy producers to readily convert their payments between the known fixed prices and the variable index prices, with no change to their respective physical energy arrangements. Thus, financial swaps are exchanges to create either fixed or index price transactions without physical changes, which are effectuated through overlays in conjunction with separate bilateral contracts. The result of a financial swap is the creation of certainty in the energy price without altering physical supply risks and arrangements.

For example, consider an industrial customer purchasing the natural gas, or any other commodity, from a supplier based on an index market price. For risk stability purposes, this end-user now wishing to have a fixed price exposure can enter into a financial swap agreement with a risk management supplier. The end-user will agree to pay a fixed negotiated price per unit of commodity to the risk management supplier over a particular contract term, and in exchange the end-user would receive payments from the risk management supplier to cover the index price of commodity for the same term and volume. This swap transaction allows the consumer to fix the commodity's price, shielding the end-user from exposure to daily market index price movements that could be financially harmful. The index price payments made by the risk management supplier to the end-user cancel out the market price paid by the end-user to the commodity supplier for the physical commodity purchase, resulting in the end-user having a fixed price for the commodity.

Financial swap agreements.

Cap (Call) Option - Hedging Commodity Requirements
By purchasing a cap option, the end-user obtains the right but not the obligation to purchase the natural gas commodity, or any other commodity, at the specified cap strike price during the specified term. A financial cap is the payment of settlement for the difference created when the index-clearing price exceeds the cap strike price during the specified term. A physical cap is the physical delivery of commodity at the strike price when the index-clearing price exceeds the cap strike price during the specified term. A cap option provides protection against a rise in the price of the commodity above the cap strike price. The cap price functions as the limit of the maximum price exposure, while retaining the flexibility to benefit from downward market prices movements. This option can be structured to provide "disaster insurance," when structured with a high cap strike price with a low upfront fee.

For example, consider an end-user paying day ahead or real-time index market prices for the commodity. The end-user want to "cap" costs, that is fix the upside price risk exposure and ensure some maximum energy cost liability, but yet remain able take advantage of the market when prices are low. To do so, the end-user would have to purchase a cap option, for an upfront fee, consisting of a strike price per unit of commodity for a specified total quantity over a specified contract term; for example, strike at $8.00 per dekatherm ("dth") for 100,000 dths over a one-year period with an upfront fee of $50,000. The end-user will continue to pay the floating market index price for the commodity when the index price is lower than the cap strike price. If the market price floats above the strike price, then depending on the structure of the transaction, for example an optional exercise or automatic exercise, the end-user exercises the cap or the cap is automatically exercised, and the end-user's exposure is to the extent of the cap strike price for the commodity. With a financial cap, the risk management supplier reimburses the end-user for the difference between the market and cap strike price, with a physical cap the risk manager physically supplies the commodity for the cap strike price.


Financial swap agreements.


A cap option is also commonly structured as an average rate look back call option. This option functions just like a regular cap option, except that when the cap strike price is triggered, the risk management supplier financially or physically reconciles with the end-user based on the difference between the cap strike price and the average index market-clearing price calculated "looking back" over the specified time period. For example, an end-user wanting to purchase the energy commodity at day ahead or real time prices, but wanting to "cap" the maximum cost, could purchase an average rate look back call option as a monthly hedge for a specified quantity of commodity over a specified term. Then, at the end of each month over the contract term, the management risk supplier would "look back" to compare the strike price to the average settlement price over the month, and pay the end-user the difference between the average settlement price and the strike price for the quantity covered by the look back call option. This option provides price protection over the selected period, but provides no protection for individual or daily price spikes. The average rate look back call option generally has a lower upfront fee than a daily option, and increasing the averaging period can further reduce the fee. This is because a longer-term average rate has lower volatility than a shorter-term average rate, especially daily and spot rates.


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