Entergy, a large electric utility is looking to fix its cost of gas purchases ov
ID: 2716745 • Letter: E
Question
Entergy, a large electric utility is looking to fix its cost of gas purchases over the next 3 years. Entergy currently buys gas in the spot market at the Henry Hub spot price. Entergy has received a proposal from Sempra Energy which would effectively fix the cost of Entergy’s gas purchases over the 3-year period via a fixed for floating (spot) swap contract, and the fixed swap price would equal $4.75 while the floating price would be the Henry Hub spot price.
a) Describe the flow of payments if both parties agree to the swap terms.
b) What is Sempra's market exposure after the swap is undertaken and what could they do to hedge it?
Explanation / Answer
a) If the Henry Hub spot price is less than $4.75 then The Entergy would pay excess of $4.75 over Henry Hub spot price($4.75- Henry Hub spot price) for the gas it purchases to Sempra Energy making net purchase price of gas for Entergy of $4.75- Henry Hub spot price+Henry Hub spot price=$4.75,$4.75- Henry Hub spot price it pays under swap contract and Henry Hub spot price it pays for gas it purchases in spot market, while If the Henry Hub spot price is greater than $4.75, Entergy shall receive excess of Henry Hub spot price over $4.75( Henry Hub spot price-$4.75) from Sempra Energy making net purchase price of gas for Entergy of Henry Hub spot price-( Henry Hub spot price-$4.75) =$4.75, Henry Hub spot price-$4.75 it receives under swap contract and Henry Hub spot price it pays for gas it purchases in spot market ,these are cash flows over the 3-year period under the fixed for floating (spot) swap contract.
b) Sempra's market exposure after the swap is undertaken is the uncertainty in the spot market of the Henry Hub spot prices that could increase to greater than $4.75 would result in the loss for them because they would have to pay excess Henry Hub spot price-$4.75 under the contract if spot prices rises therefore there is a risk or market exposure that can affect them negatively of spot prices rising unexpectedly very high.They could hedge it by becoming long in gas futures contracts or gas options contracts or arranging a offsetting swap that is taking a reverse position to the existing contract of being long on gas spot prices .
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