Oct 25, 2008

The downside of hedging

The graph below shows the spot price of natural gas. In Texas, because our power grid is relatively isolated from other states, and because +60% of our power generation is driven by natural gas, our electricity rates are highly correlated with the price of NG. Those of us on a month-to-month electric plan saw huge increases in the spot rate for electricity, going from $0.10/kwh to $0.205/kwh in August. The seemingly endless increases led me to sign a one year contract for wind energy at $0.145/kwh on the day indicated on the graph. Of course, no sooner than I had locked in my rate (with a cancellation fee if I leave) than the price of NG entered a freefall. I don't mind paying a little extra for "green" electricity but this just illustrates one of the risks inherent in hedging. Homeowners in the northeast are reporting similiar frustrations after they locked in heating oil prices over the summer and now the spot rate has fallen precipitously.

On the other hand, a friend of mine sold the mineral rights to the natural gas under his house for a tidy sum right around the same point in time. He had resisted the company's initial offers until they increased their bid. Now that NG prices have collapsed, the company has stopped buying homeowners' mineral rights. Some of his neighbors held out too long, and now there is no deal for them at any price.

In a broader sense, when we enter into a financial transaction, it's worth taking a moment to think about who is sitting on the other side of the table. What do they know that I don't? For share of stock that has been sold during the recent market turmoil, an equal number of shares were purchased at the same price.

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