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If you can keep your head ...

February 2014

  • Commodity markets tend to react dramatically to surprises, and the recent gas market behaviour is an example.
  • If buyers recognize this recent price movement is a short term phenomenon, they can make rational choices to minimize the short term impact where possible.
  • A well-designed risk management strategy should account for the kinds of market events we are seeing. Even if the exact timing, cause and extent of a market surge are not perfectly foreseeable, it should be well understood that they will happen. So they should be planned for.

Natural gas prices across North America have shown remarkable volatility in recent weeks, as cold and stormy weather persists in an unusually harsh winter. Storage inventories are being drawn down at record rates, which is putting upward pressure on prices for February and March as the market will remain tight for the rest of the heating season. And the hard pull on storage increases demand for summer gas to replenish inventories, which in turn is providing support for summer prices.

Commodity markets tend to react dramatically to surprises, and the recent gas market behaviour is an example. Prices for the March natural gas futures contract climbed above $5.60/MMBtu in the first week of February, 33% above its price at the end of December. The Dawn index price, which averaged $4.05 in January, hit $25.54/MMBtu for one day on January 27 and averaged $10.99 in the first 5 days of February. In Alberta, the daily AECO spot price settled at almost $25/GJ for February 5.

These are prices not seen in years, and prices that certainly were not foretold in the months leading into winter. Many gas consumers will be hit by the combined impact of these increased prices as well as increased consumption due to the colder weather.  Many will be saying “If only I had hedged more!” or “What if I lock in prices now, can I avoid this craziness?”

Victorian-era writer and poet Rudyard Kipling’s well-known poem “If” provides some guidance:

“If you can keep your head when all about you are losing theirs…”

  • Two months of unusually high prices in a year’s worth of gas purchasing affect about 16% of the buyer’s gas purchases by volume. Gas prices that are 60% higher than normal in those 2 months would increase the buyer’s annual gas cost by about 10% overall. This is not to minimize the impact of a 10% budget overrun, but it does put it in context.
  • Commodity markets are “mean-reverting”. When a shock pushes the market above normal prices, it will tend to return to normal given time. In the midst of the shock is often not the best time to do what you wish you’d done before the shock. A high forward price does not become your price until you buy it. While the March futures contract was above $5.60 on February 5, it was trading below $4.80 on February 7.

“If you trust yourself when all men doubt you, but make allowance for their doubting too”

Aegent encourages energy buyers to have a buying team, a cross-functional group engaged in the risk management decisions. If several different perspectives from within the organization are involved in setting the risk management strategy, then it should reduce the number of men and women doubting you when things don’t go perfectly, because they will all have a good understanding of the strategy and why it was adopted.

A well-designed risk management strategy should account for the kinds of market events we are seeing. Even if the exact timing, cause and extent of a market surge are not perfectly foreseeable, it should be well understood that they will happen. So they should be planned for.

This doesn’t mean hedging everything forward all the time. Studies show that buyers pay less in the long run if they do less risk management rather than more. The right amount of risk management is the amount that takes the unacceptable outcome off the table, but removing all risk is too expensive. It would be like having zero deductible on your car insurance.  While it may feel good the one time you make the claim, the years of higher premiums would outweigh the benefits.

So even if the current market behaviour means your gas costs will be higher this year than you’d like, you can still trust your strategy if: 1) you are confident it is the right strategy in the long term and 2) it allows you to absorb the short term hit without serious consequences.

But trusting your strategy doesn’t mean never questioning it. When you encounter a bump in the road like this, it is always a good idea after the fact to review the outcome and assess whether a change in the strategy or a more sophisticated approach is called for in order to be better prepared next time. If anything, the recent events point to the fact that market view and weather forecasts are not in themselves sufficient tools for gas price risk management, because they will be wrong from time to time.

If buyers recognize this price movement is a short term phenomenon, they can make rational choices to minimize the short term impact where possible, and then conduct an effective review of their strategy once the dust settles.

The Hidden Opportunity Cost of Hedging Read more»

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