Looking for more budget certainty around energy expenses? Consider an energy hedging program.
By David R. Brayshaw, Senior Vice President at HilltopSecurities
Over the past 24 months, the price of energy products like natural gas, diesel fuel, gasoline, and power have plunged, providing opportunities for energy managers to lock-in some of the lowest energy prices in decades. Natural gas futures, for example, have declined to their lowest level since 1999 as forecasts for unusually mild weather signal that a supply glut will persist into the peak of the heating season. Gas was one of the worst-performing commodities in the 2015 Standard & Poor’s GSCI index as mild weather limited heating demand in the U.S. East, leaving the biggest stockpile surplus since 2012 intact.
Volatile energy prices can make managing an energy budget no easy task. As you may know, the price of commodities, such as natural gas or diesel fuel, fluctuates widely over time. Commodity prices are generally affected by a confluence of uncontrollable factors, including weather, new technology, geopolitical forces, and market sentiment. Any one of these factors can have a profound impact on a financial manager’s bottom line.
Many financial managers turn to the commodity market for short-term relief and to develop formal hedging programs that can provide long-term energy price management. Most hedging programs, as a matter of policy, formalize the risk management process, and they are typically designed to manage energy price volatility and improve budget stability. With the economy showing signs of recovery and commodity prices currently at attractive levels, is it time to consider hedging your energy costs?
How Can I Hedge?
There are several ways to hedge energy costs. Sometimes financial managers use physical delivery contracts, other times they use exchange-traded futures, and in some cases they even use over-the-counter swaps to protect themselves against large price swings in the energy market. Each hedging method has its own advantages and disadvantages, but which is the most effective for your organization?
Many businesses and institutions already effectively hedge against price swings by locking in physical delivery contracts with energy suppliers. In a physical delivery contract, a business enters into a fixed price agreement with their energy suppliers in exchange for their physical delivery commodity. These physical delivery contracts are commonly called producer price agreements. Suppliers are not always chosen for price alone, but often are considered on the basis of service, reliability and quality.
Exchange Traded (Futures)
Exchange-traded hedging involves buying and/or selling futures contracts. In order to manage risk, the buyer can lock in the price they pay for a commodity in advance. Prices are based on current spot markets, i.e. the price of energy traded today, and on future market traditions. The price locked-in will equal the average of all futures contracts bought or sold in a single hedge transaction.
An over-the-counter (OTC) swap is a contractual obligation between two parties to exchange a series of payments for a stated period of time. Keep in mind, however, that these two parties are not “betting” against each other; a swap counterparty serves as an intermediary between clients who wish to hedge opposite exposures.
|Future Contracts||Swap Agreements|
There are several factors that must be considered when deciding which hedging method to use. Since energy market analysis may not have a place in your daily practice, it may be worth considering the use of a qualified Commodity Trading Advisor to save yourself time and provide market expertise. CTAs are able to advise on the development of a suitable risk management program and help with any required staff and board education. Since every financial manager has their own business requirements and preferences when it comes to developing an energy hedging policy, it’s appropriate to develop a hedging policy that meets the specific needs of your organization. By implementing a formal hedging program, you will ensure best practices within your organization. By hiring a CTA, you can ensure efficiency in all phases of program development and implementation, which include analysis, documentation/ authorization, execution, post-trade maintenance and surveillance.
When used as a means to lock in energy costs for activities ranging from daily business operations to capital improvements, the use of hedging programs can provide managers with more accurate forecasts of expenses and profit margins, and also provide mitigated exposure to volatile energy markets.
Since program expenses and risks will vary from program to program, no single hedging program or strategy is right for all users. However, in all cases, implementation requires up-front work to determine feasibility and applying an appropriate strategy. In addition, businesses and institutions must develop documentation that supports the program and procedures for trade execution. To be successful, program implementation requires due diligence, careful planning and effective execution.
Given the complexity and specialized focus in energy hedging, engaging a CTA can provide your organization with a cost-effective means of evaluating, establishing and monitoring an energy hedging program. For more information, contact Dave Brayshaw at 214-953-4020 or Dave.Brayshaw@hilltopsecurities.com.
Suitability of products mentioned herein must be determined on an individual basis. Not all products are suitable for all investors. Additional investor education is available through: FINRA (Financial Industry Regulatory Authority) at www.finra.org; Securities Industry and Financial Markets Association (SIFMA) at www.sifma.org; and Municipal Securities Rulemaking Board (MSRB) at www.msrb.org, EMMA (Electronic Municipal Market Access) System at www.emma.msrb.org, or DPC Data’s MuniFilings at www.munifilings.com.