June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 16 of 92 2.1.1. Natural Gas Marketing Company Example A Natural Gas Marketing Company has the following characteristics: • They are long natural gas • They possess pipeline and storage assets (implying they are long volatility, as well). • They hedge a large portion of their long physical positions with financial instruments (sell forward). Assuming that natural gas prices in the company’s region of activity have spiked dramatically and, correspondingly, volatility has also increased, Figure 2.2 illustrates the potential chain of events and how Economic Value and Financial Liquidity are affected by the same event. Figure 2.2 – Commodity Price Spike Effect on Balance of Capital Adequacy In this case, the increased prices and volatility has driven up the value of the physical positions and the assets of the company, thereby increasing the Economic Value. However, this same price behavior has resulted in margin calls for the financial hedges. This has constricted the company’s liquidity, thereby reducing Financial Liquidity. It is important to note that the increased value of the assets may result in additional collateral being used to arrange credit facilities that will enhance the company’s financial liquidity. Because the price movement of natural gas in the above example affects both financial liquidity and economic value, that price movement should be assessed to answer the following questions: • What does this do to my ability to service short term obligations (Liquidity Adequacy)? Value of Assets Increase Value of Physical Inventory Increases Value of Financial Shorts Decreases Increases Value of Collateral Equity Increases Margin Calls are Triggered Financial Liquidity Economic Value NG Prices Spike NG Volatility Increases Event Result Impact Capital Effect