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Swaps/Contracts for Differences

Like forwards and futures, swaps allow you to fix the price for energy purchased or sold in the future, whether next month or years ahead. In a swap one party exchanges floating rate risk, usually based on a specific index, for a predetermined fixed rate. Because swaps are a financial rather than a physical product, settlements are made in cash. Each month, the parties exchange payment, one party always paying the fixed rate, the other returning a variable payment based on the indexed price. The financial nature of swaps makes them an effective way to lay off price risk associated with existing long-term variable contracts.

Example: An electric utility has a two-year gas supply contract pegged to a regional index. However, the utility is concerned about its exposure to natural gas price volatility. As a result, it enters into a swap with Mirant to exchange that index price for a fixed price of $3.00/MMBtu. Each month the utility sees three cash flows:

(1)

the utility pays the natural gas supplier the index price for its gas

(2)

the utility receives that same index price from Mirant

(3)

the utility pays the fixed price payment to Mirant

Because cash flow (1) to the supplier and cash flow (2) from Mirant exactly offset each other, the net payment from the utility is the fixed payment in cash flow (3) to Mirant. The following two-month illustration will clarify:

Month 1

Index price: $3.20/MMBtu

Fixed price:  $3.00/MMBtu

Quantity:     10,000 MMBtus
Party Receives Pays Net
Supplier $32,000
from Utility 		($0) $32,000
Utility $32,000
from Mirant 		($32,000)
to Supplier		 ($30,000)
to Mirant
Mirant $30,000
from Utility		 ($32,000) ($2,000)

Month 2

Index price: $2.90/MMBtu

Fixed price:  $3.00/MMBtu

Quantity:     10,000 MMBtus
Party Receives Pays Net
Supplier $29,000
from Utility 		($0) $29,000
Utility $29,000
from Mirant 		($29,000)
to Supplier		 ($30,000)
to Mirant
Mirant $30,000
from Utility		 ($29,000)
to Utility		 ($1,000)

At the end of each month, you can see that while the supplier received the correct index price due, the utility has paid only the fixed price of $3.00/MMBtu. In each case the payment difference and the risk have been transferred to Mirant.