Although some consider Hedging to be an advanced and difficult to discern concept, the execution of hedges is in fact extremely basic. Risk managers can use futures contracts, over-the-counter swaps, call and put options, and combinations thereof to lock-in prices for a given period. This allows a company to know exactly what they will pay for their energy during that time and plan for that price accordingly. The real challenge of hedging is setting up a strategy that matches a company’s risk appetite and hedging goals.
Hedging to Mitigate Risk
Hedging is especially significant for companies that produce or consumer large quantities of energy such as natural gas, crude oil, etc. However, many companies look at hedging as a profit strategy, which it is not. The point of hedging is not to make money (nor lose money) but rather mitigate risk. That, in and of itself, is another term that needs to be defined. In some cases, a company’s risk will be based upon the price that they will purchase or sell their energy. For others, risk could be defined as the cost of opportunity to transact at a lower or higher price so that they may use 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 hedge program seek out a well-qualified hedging strategy that meets their unique goals and risk appetite. The first step in this is to define their risk and the goals of the hedge program, then create a strategy that uses the right hedging instruments at the right time to fit their needs.
Here are a couple of tools to help manage hedging programs:
Futures are the basic contract to buy a predefined asset of standardized quantity, on a certain date at a certain price. Future contracts are ensured by a clearinghouse, which limits the risk of opposite party default. Forward contracts are a standard contract between two parties and doesn’t have as inflexible terms and conditions, as a futures contract. Moreover, there are chances of opposite party defaulting on its commitment.
Options are a very flexible hedging tool. An organization or investor can buy a ‘call’ option, which is the entitlement to purchase an asset at a specific price, or a ‘put’ option, to sell at a specific price at a future date. Unlike futures the option owner isn’t required to consummate the transaction if the market price is more profitable than the option price.
Natural Gas Example
For the first eight month’s of 2015 natural gas prices traded in a sideways range between nominally $2.50 and $3.00 per MMBtu. Then, in September 2015 prices broke lower out of the rang and ultimately fell 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 such a project they needed gas prices to remain 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 also does not want to risk higher prices. Therefore, their 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 also have more downside risk than using options. Options would limit the risk to the cost of the option’s premium, but prices would have to fall well below $2.50 so that the “all-in” cost of the strategy, that is the option strike price plus premium, does not exceed $2.50.
Either way, in this case the utility knows what their goal is and can create a strategy to time the hedges once prices fall below $2.50. Once they can lock in natural gas prices they will know that it is safe to move forward with the new power plant. If prices did not fall that low they would know that they can’t move forward with the project.