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How a gas utility uses a floor to protect revenue during a mild winter
X Gas Co., a gas utility located in the northeastern U.S., has reported a first quarter drop in earnings of 15% compared to Q1 of the previous year. Furthermore, the previous year's Q1 results were 11% lower than the year before. In both instances, the company attributed the losses to milder than normal winters.
Management wishes to protect the company against further low earnings, but at the same time take advantage of the revenues that can arise during the potentially profitable winter season.
Historical data suggests a high correlation between underlying winter weather and the overall quantity of MMBtus distributed by X Gas Co. Known supply costs allow management to determine potential revenues given a range of cumulative heating degree day (HDD) scenarios during the forthcoming November to March. For example, the average number of HDDs for this period over the last 30 years is 5,330. Budgeted revenues for this number of HDDs in terms of MMBtus sold are $50mm. X Gas Co. estimates that, at the margin, each HDD deviation depresses revenues by $12,500. Management is therefore concerned that if the weather is more than 7.5% warmer than average (i.e., there are only 4,930 HDDs), revenues would fall by more than 10%.
In exchange for a premium payment, Enron provides X Gas Co. with a floor of 4,930 HDDs, cumulative over the November to March period, as measured by a National Weather Service station in the company's service territory. For every HDD under this level, Enron will pay the company $12,500.
With this floor protection, X Gas Co. has purchased protection that should help it achieve volume-related revenues associated with weather of at least 4,930 HDDs while retaining all revenue associated with the weather being colder than the strike.
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