Importance of hedging energy commodities

Although hedging is considered by some to be an advanced concept and difficult to discern, hedging execution is, in fact, extremely basic. Risk managers may use futures contracts, OTC swaps, call and put options, and combinations thereof to set prices over a given period. This allows a business to know exactly how much it will pay for its energy during that time, and plan that price accordingly. The real challenge in hedging is establishing a strategy that matches a company’s risk appetite and hedging objectives.

Coverage to mitigate risk

The coverage is especially significant for companies that produce or consume large amounts of energy, such as natural gas, crude oil, etc. However, many companies view hedging as a profit strategy, which it is not. The goal of hedging is not to make money (or lose money), but to mitigate risk. That, in itself, is another term that needs to be defined. In some cases, a company’s risk will be based on the price at which it will buy or sell its energy. For others, risk could be defined as the opportunity cost of transacting at a lower or higher price so that they can use the funds saved to move forward with other projects or technologies.

The bottom line is that no two companies share the same risks. Therefore, it is crucial for anyone looking to implement a hedging program to seek out a well-qualified hedging strategy that meets their unique objectives and risk appetite. The first step in this is to define your risk and hedging program objectives, then create a strategy that uses the right hedging instruments at the right time to meet your needs.

Here are a couple of tools to help manage coverage programs:

Futures/forward contracts

Futures are the basic contract to buy a predefined asset of standardized quantity, on a certain date at a certain price. Futures contracts are guaranteed by a clearinghouse, which limits the risk of default by the opposing party. Forward contracts are a standard contract between two parties and do not have as inflexible terms and conditions as a futures contract. Also, there are chances that the opposing party will renege on their commitment.

Options

Options are a very flexible hedging tool. An organization or investor can buy a ‘call’ option, which is the right to buy an asset at a specific price, or a ‘put’ option, to sell it at a specific price at a future date. Unlike futures, the option owner is not required to consume the transaction if the market price is more profitable than the option price.

Natural gas example

During the first eight months of 2015, natural gas prices traded in a sideways range between $2.50 and $3.00 nominally per MMBtu. Then, in September 2015, prices broke out of the range, finally falling to $1,611 in March 2016, an eighteen-year low. Let’s say that during this time there was a utility company that wanted to build a new gas-fired power plant, but to finance such a project they needed gas prices to stay below $2.50 for the next year.

In this extreme example, the company does not want to miss out on the opportunity to build the new facility, but it also does not want to risk higher prices. Therefore, your goal is to lock in prices using futures or calls once prices fall below $2.50. Using futures would limit the cost of the hedge, but would also have more downside risk than using options. Options would limit risk to the cost of the option premium, but prices would have to fall well below $2.50 for the “all-in” cost of the strategy, that is, the option strike price plus the premium, not to exceed $2.50.

Either way, in this case the utility knows what its objective is and can create a strategy for scheduling coverage once prices fall below $2.50. Once they can lock in natural gas prices, they’ll know it’s safe to go ahead with the new power plant. If prices didn’t drop so low, they would know they can’t go ahead with the project.

conclusion

Organizations hoping to protect themselves from wild market fluctuations would be better served by at least investigating what an explicit hedging program offers the business. Market participants should be able to smooth out price swings and create a strategy that fits their unique goals and risk appetite. A well-defined hedging program is an essential part of mitigating energy price risk, and the right strategy and tools can help achieve a company’s hedging and risk management objectives.