Hedging, a tool for price risk reduction, not cost reduction

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 commonly 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 and “lock in savings”. But the energy market is inherently uncertain, and no one can consistently predict market direction or 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 should be seen a tool for price risk reduction, not for cost reduction.

Said another way, the goal of hedging is to make an expected price outcome more certain and less uncertain. In a so-called “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. But since we don’t know what the market will do, that perfect hedge may end up above the market or below the market.

How can the hedge be “perfect” if it cost us money as compared to not hedging?

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 interested in only in hedges that would be “winners” after the fact, they would always be uncertain when to hedge, leaving themselves open to price risk.

Let’s look at how the two alternative perspectives on hedging play out in the context of a market in which prices are falling after a recent rally.

The buyer who looks on hedging as a cost reduction tool will see prices falling and will be looking for the bottom in order to lock in. “When prices fall to $3/GJ I will lock in”.

But stated another way, this strategy implies: If my price falls a certain amount, I will stop it from falling further. But if it does not fall that much, I will not prevent it from rising.

Does this make sense?

A buyer applying this strategy consistently will cut off market declines prematurely – preventing herself from paying lower prices – while leaving herself open to market increases. This approach neither reduces cost nor reduces risk.

A buyer who looks on hedging as a risk reduction tool would let a falling market continue to fall since risk is reducing. No hedge required. Instead, she would hedge when increasing prices present a threat to the budgeted price outcome. If the market continues to rise, she will continue to buy and will have layered all her hedges in before the market price exceeds her budget.

A buyer applying this strategy would fully enjoy market declines but cut off market increases, thus limiting the impact of unfavourable market movements, while benefiting from favourable ones. This way, she controls risks and reduces her costs over the long run.

JUPITER’s analysis of the gas market supports analysis done by others in other volatile markets:

• Buyers pay less over the long term if they float with the market rather than locking in a forward price.
• However, in a market that can be very volatile, the magnitude of possible price changes in the short term can be enough to negatively affect buyers to a material degree.

The challenge then is to manage risk in the short and medium terms in a way that minimizes costs over the longer term. That is where hedging comes in, as a tool for controlling risk by keeping energy prices and price changes within acceptable limits – when hedging is needed, but only to the degree it is needed.

As a risk management tool, hedging should not be applied mechanically or routinely, but instead selectively, and proactively -- when the risk of an adverse price change is unacceptably high. Remember hedging costs money, so only do as much as needed to control cost outcomes within an acceptable limit. That is the efficient approach to hedging – buying the just required amount of risk management at least cost.

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.