Significance of Hedging Energy Commodities
Even though some people think that hedges are complicated and difficult to understand, they are actually very easy to put into practice. To lock in prices for a specific time, risk managers can use futures contracts, over-the-counter swaps, call and put options, and combinations of these. A business is able to plan for the exact price they will pay for energy during that time because of this. The most difficult part of hedging is devising a plan that fits a business’s risk tolerance and hedging objectives.
Hedging to Reduce Risk Hedging is especially important for businesses that produce or use a lot of energy, like natural gas, crude oil, and so on. However, hedging is not considered a profit strategy by many businesses. Hedging is not about making money or losing money; rather, it is about reducing risk. That in and of itself is a term that requires definition. The price at which a company buys or sells its energy may in some instances determine its risk. Others may define risk as the cost of an opportunity to transact at a lower or higher price in order to save money for future projects or technologies.
In the end, no two businesses face the same risks. As a result, it is absolutely necessary for anyone planning to implement a hedge program to look for a well-qualified hedging strategy that satisfies their particular objectives and risk tolerance. Determining their risk and the objectives of the hedge program are the first steps in this process. Next, a strategy that makes use of the right hedging instruments at the right time to meet their requirements is developed.
Some tools for managing hedging programs are as follows:
Futures and Forward Contracts Futures are the fundamental contract for purchasing a predetermined asset in standardized quantities at a predetermined price on a predetermined date. A clearinghouse guarantees future contracts, reducing the likelihood of the opposite party defaulting. As opposed to a futures contract, a forward contract is a standard contract between two parties with less lenient terms and conditions. In addition, there is a possibility that the opposing party will not keep its word.
Options Options are a very adaptable tool for hedging. An organization or investor can purchase a “call” option, which entitles them to purchase an asset at a predetermined price, or a “put” option, which entitles them to sell the asset at a predetermined price in the future. If the market price is greater than the option price, the option owner is not required to complete the transaction, in contrast to futures.
Example: Natural gas prices fluctuated sideways between nominally $2.50 and $3.00 per MMBtu for the first eight months of 2015. The prices then broke out of the range in September 2015, eventually falling to $1.611 in March 2016, an eighteen-year low. Let’s say that a utility at the time wanted to build a new gas-fired power plant, but they needed gas prices to stay below $2.50 for the next year in order to finance the project.
In this extreme case, the business does not want to risk higher costs while also not passing up the chance to construct the new facility. As a result, once prices fall below $2.50, their objective is to use futures or calls to secure prices. The cost of the hedge would be lower if futures were used, but there would be more downside risk than if options were used. Options would limit risk to the cost of the option’s premium; however, prices would need to drop well below $2.50 in order to keep the strategy’s “all-in” cost, which is the option strike price plus the premium, below $2.50.
In any case, the utility is aware of their objective and is able to devise a plan to time the hedges when prices fall below $2.50. They will know that they can proceed with the new power plant safely once they are able to lock in natural gas prices. They would be aware that they would be unable to proceed with the project if prices did not fall that low.