Although hedging is considered by some to be an advanced concept and difficult to discern, the execution of hedging is, in fact, extremely basic. Risk managers may use futures contracts, over-the-counter swaps, call and put options, and combinations thereof to set prices for a given period. This allows a company to know exactly how much it will pay for its energy during that time and to plan that price accordingly. The real challenge of 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 might be defined as the opportunity cost of transacting at a lower or higher price so that they can use the saved funds to move forward with other projects or technologies.
The bottom line is that no two companies share the same risks. Therefore, it is crucial that anyone looking to implement a hedging program find a well-rated hedging strategy that meets their unique objectives and risk appetite. The first step in this is to define your risk and hedging program goals, 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 a standardized quantity, on a certain date at a certain price. Futures contracts are guaranteed by a clearing house, which limits the risk of default by the other party. Forward contracts are a standard contract between two parties and do not have as inflexible terms and conditions as a futures contract. In addition, there are chances that the other party will renege on its 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 specified price, or a ‘put’ option, to sell it at a specified price at a future date. Unlike futures, the owner of the option 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 nominally $2.50 and $3.00 per MMBtu. Then, in September 2015, prices moved 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 that wanted to build a new gas-fired power plant, but to finance said 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 building 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 drop below $2.50. Using futures would limit the cost of hedging, but would also carry more downside risk than using options. The 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, do not exceed $2.50.
Either way, in this case the utility knows what its goal is and can create a strategy for scheduling coverage once prices drop 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 the prices didn’t fall so low, they would know that they can’t go ahead with the project.
Conclusion
Organizations hoping to protect themselves from uncontrolled 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 ups and downs and create a strategy that fits their unique objectives 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 risk management and hedging objectives.