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Merchant power plant is one that can be turned on whenever you want. Suppose it is generating electricity from natural gas and we have a spark-spread option. Why is that the person who owns plant is said as long the power and short the natural gas? Shouldn't it be the opposite where he short power and long the natural gas?

I am little confused why it long the power and short the natural gas?

Need some guidance.

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up vote 2 down vote accepted

When you have a power plant, your gain (financial) is Power Price - coef1 * Gas Price - coef2 * CO2 Price - other cost. So if you want to secure your supply, you have to be Long Gas and CO2 and Short Power.

Physical commo is the opposite, you are short gas and long Power (when the Power price rise, you earn more money).

Financial strategies must be opposite of Physical position to secure the margin.

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I am not sure I agree with "Physical commo is the opposite, you are short gas and long Power (when the Power price rise, you earn more money)". If you own the physical commodity (say gas) your are simply long the physical commodity. If you are a middle man in the physical commodity space you buy and sell the physical commodity, leveraging your infrastructure. I may have misunderstood your point here. – pincopallino Apr 15 '14 at 7:32
@selfTaught I may have misunderstood your potential misunderstanding, but: When you are the producer, you buy the spot NG without the intention of later selling it but instead for using it as an input. It can be considered as a cost of electricity. I suppose you are long the physical commodity in the sense that you own it, but you do not benefit from price appreciation (unless you plan to later sell it, which is only the case in extreme price movements after purchase and before usage). Instead, NG price appreciation is detrimental since you buy continually. – Jacob M. Morley Apr 15 '14 at 16:34

As alexis0587 said, with any gross producer margin (GPM) spread, you capture the differential of outputs less inputs since that reflects your profit for running the plant:

$$\pi = p_e-p_{ng}-p_h-\kappa$$

where $\pi$ denotes profit, $p_e$ electricity price, $p_{ng}$ energy-equivalent factor adjusted natural gas price, $p_h$ equivalent factor adjusted emissions costs, and $\kappa$ denotes maintenance and other costs.

So effectively, if the spark spread increases (decreases) as you are operating the plant, $\pi$ incrases (decreases). Your position behaves as though you are long the synthetic asset of "spark spread" which is inherently long electricity and short natural gas.

I suspect this may be confusing you: as a producer, you may wish to hedge against increasing natural gas prices by buying futures, say, thereby being long the inputs, but the hedge is to offset potential losses incurred from holding your primary position of long the GPM spread (long outputs, short inputs).

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