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Hedging: A Tool for Risk Reduction, Not Cost Reduction

July 2014

  • The energy market is inherently uncertain, and no one can consistently predict market direction and the timing of market movements.
  • Analysis has shown that buyers pay less over the long term if they float with the market rather than locking in a forward price. However, the market is very volatile, and the magnitude of possible price changes in the short term is enough to create significant risk for buyers. The goal is to be able to survive the short term in order to enjoy the long term.
  • Hedging is a tool for controlling risk to keep energy prices and price changes within acceptable limits. It is not a cost reduction tool.

Energy buyers are tasked helping their organizations lower costs and manage cost uncertainty on the energy they need to operate. Energy price hedging is an important tool for accomplishing that goal. But to hedge effectively, we must clearly understand what hedging is for, and what it is not for. Only with the goals clearly in mind can we implement a strategy that will be successful.

In talking with energy buyers, it emerges that many view energy buying as a speculative process. They see their job as requiring them to understand where the market is going next, so they can buy at the bottom. But the energy market is inherently uncertain, and no one can consistently predict market direction and the timing of market movements. Sounds like a stressful situation for these buyers!

The problem stems from a fundamental misunderstanding about what hedging is, and how and when to use it.

Hedging is a tool for risk reduction, not a tool for cost reduction.

Aegent’s analysis of the gas market supports analysis done by others in other volatile markets, which has shown that buyers pay less over the long term if they float with the market rather than locking in a forward price. However, the market is very volatile, and the magnitude of possible price changes in the short term is enough to create significant risk for buyers. The basic strategy then is to be able to survive the short term in order to enjoy the long term. That is where hedging comes in, as a tool for controlling risk to keep energy prices and price changes within acceptable limits.

Said another way, the goal of hedging is to make a certain price outcome more certain and less uncertain. In a perfect hedge, the energy buyer is completely indifferent to the movement of market prices…the price to the buyer will remain the same no matter what the market does.

The objective of a hedge is not to ensure that the buyer’s cost is lower than it would have been without the hedge. That outcome can only be assessed after the fact. And if buyers were only ever interested in hedges that would be seen as “winners” after the fact, they would often not enter into a hedge, and end up taking on undue risk in the pursuit of cost savings.

So, how does a buyer balance the sometimes conflicting goals of managing risk while also lowering costs? The key strategy is to hedge as little as possible, and in fact to hedge only as much as needed to control cost outcomes within an acceptable limit.

Let’s look at a practical illustration of the difference in these approaches.

Prices are falling after a recent rally. The buyer who looks on hedging as a cost reducing strategy will see prices falling and will be looking for the bottom in order to lock in. “When prices hit $4 I will buy”. If he does so, and the market then keeps falling he will end up having entered into an unnecessary hedge. Prices were falling, what risk was being managed? He also will have incurred above-market costs since he is paying $4 and the market is below that.

A buyer applying this strategy consistently will consistently cut off market declines prematurely, while leaving himself open to market increases. This neither reduces cost nor reduces risk.

A buyer who looks on hedging as a risk reducing strategy would let the market continue to fall, and only buy in an increasing market, and if the market continues to rise, he will have all his hedges in place before the market price exceeds his budget.

A buyer applying this strategy would cut off market increases, but fully enjoy market declines, thus limiting the impact of unfavourable market movements, while benefiting from favourable ones.

Those who see hedging as a tool for risk reduction know that the time to hedge is when the risk of an unfavourable outcome is getting too high. Those who are trying to use hedging to achieve the lowest cost are using the wrong tool for the job.

The Hidden Opportunity Cost of Hedging Read more »

Think of Hedging as Just an Umbrella for Unpredictable Weather Read more »