Shale gas boom gives U.S. manufacturers an edge—Keeping the edge, Part 2

As discussed in Part 1, the U.S. shale gas boom has made natural gas plentiful and cheap, giving U.S. manufacturers a competitive edge over rival manufacturing countries where the price of natural gas and electricity is several times higher.  (The U.S. edge has some staying power. Consider China, where the challenges of producing shale gas are significant. In less government-supportive locations like Europe, it's even more challenging.) Energy companies and petrochemicals manufacturers from Exxon-Mobil to Dow are building enormous facilities to process natural gas to produce ethane and propane, then ethylene and propylene, the most important raw materials in the petrochemicals industry.

The advantage to U.S. manufacturers is largely dependent on natural gas staying cheap and plentiful. From a supply perspective, it's easy to think natural gas prices have nowhere to go but sideways.

However, with demand (petrochemicals manufacturing, electricity generation, transportation, and LNG exports) catching up with supply—and the relentless opposition to hydraulic fracturing from the EPA and some environmental groups—there's a chance natural gas won't stay cheap. In fact, if Ron Binz—Obama's nominee for chairman of the Federal Energy Regulatory Commission (FERC)—has his way, natural gas prices will increase. According to the WSJ, Binz's "overriding policy motivation is to make carbon more expensive so it can be phased out of the U.S. economy." Binz makes clear "what the green left really thinks about natural gas. They loved gas when it was scarce and expensive. But now that it is abundant and cheap, gas poses a threat to the dream of an economy run solely on mandated renewables. So the strategy is to use regulation to slowly make natural gas more expensive again." FERC oversees much of the gas business-from pipelines to export terminals to trading markets.

So demand and environmental agendas could lead to higher and more volatile gas prices. Consider what happened in 2005 and again in 2008 when there was much less demand and much more gas in the ground.

With so much riding on cheap natural gas, if the possibility of higher average prices or a price spike is 10% or more in the next few years, manufacturers and their customers (resin processors!) would be wise to insure against the risk of higher prices. Frankly, at current low prices ($3 to 4 per MCF - barely breakeven for some natural gas producers), it would be careless if they didn't.

"Insurance!?" exclaimed the manufacturer. "The cost of such insurance is too expensive!" That's not true for several options hedging strategies, but particularly the one I recommend - a bull fence.

Fence in Natural Gas
And, in a few years, ethylene and propylene prices, too

A bull fence is an option strategy for buyers of a commodity to limit price risk at low-to-no cost. This involves the sale of a put option with all or part of the premium received used to buy a protective call option. If the strike prices of the put and call options are equidistant from the underlying commodity price, then the net cost of "insurance" may be zero.

The call and put options have the same expiration date. The call option establishes a ceiling or cap price for the commodity, while the put option establishes a floor price, thereby "fencing in" the commodity price.  This hedging strategy is also known as a "costless collar". It is most effective and appropriate when a commodity price is near its breakeven production cost, as is natural gas below $4 per MCF in the U.S.

A buyer of natural gas in January 2015 could—for just $0.05 per million Btu—cap the price of gas at $4.75 and possibly own the gas at $3.75. The buyer is completely protected against the risk of higher natural gas prices for very little cost.

Fence in Resins Prices
The same fence strategy can be applied directly to resins purchases. Processors should explore the possibility of building price fences with resin suppliers who may appreciate how the fence also reduces their price risk.

About the author: Tom Langan is an energy and petrochemicals cost and revenue risk manager dba WTL Trading. He helps buyers and sellers of commodities control costs, secure profit margins, and increase sales. Articles in the Hedging Corner are selected from Tom's own Hedging Corner blog.