Financial energy price hedging mitigates price volatility for large consumers of energy.
Sometimes it costs far more to do nothing at all, than to take action in response to change. For large consumers of energy, this is all too true, as markets fluctuate and price volatility abounds. Utilities and industrial consumers of petroleum products and natural gas operate in an environment subject to diverse price movement in the international oil & gas market. This exposure to such risk is enough to increase a company’s costs or dramatically reduce its profits. As risk exposure reduces the end user’s appeal to investors and makes gaining access to debt markets more difficult, the need to efficiently manage exposure to fluctuating commodity prices is clearly one of the greatest challenges facing oil & gas end users today.
Most bulk users of energy will continue to directly negotiate rates with their local suppliers. But, to augment or partially replace directly negotiated rates, an increasing number of bulk users are considering “energy hedging,” or energy risk management financial strategies that allow them to budget and plan for the months or years ahead regardless of what is going on in the energy markets, or the price per barrel of oil. Hedging stabilizes cash flows, reduces the cost of capital, secures company objectives, and enables management to measure performance.
Impact of Energy Hedging on Suppliers
It is important for all constituents in the utilities industry, including suppliers, to understand how bulk users of energy address these changing forces. The use of proactive energy risk management is changing the business for power companies, their largest clients and the suppliers and vendors alike. The users are not just trying to save a buck, or to beat the markets. They are trying to maintain their ability to budget and plan by smoothing hydrocarbon costs over time, in order to create budgetary certainty in times of change.
This change in paradigm impacts suppliers, because when users can predict their costs, it brings a sense of stability to the power industry as a whole. Worries that budget cuts will affect demand for power or gasoline are virtually eliminated, and concerns regarding payment for power are reduced. That stability in turn benefits utility companies and their suppliers.
Energy Risk Management 101: What is Energy Hedging?
So how are financial institutions creating this sense of financial calm amidst markets that fluctuate faster than gas stations can change their signs? At the core of the strategy, energy hedging separates supply and price issues. In this manner, the financial hedging of energy risk means that users of petroleum products, natural gas or other fuels can take advantage of market opportunities without sacrificing the ability to fix ongoing costs and minimize procurement fees. These strategies are not considered investments, since no funds are at risk.
Large users of gasoline, diesel, natural gas and power are typically either public sector entities (counties, cities, municipalities or other types of governmental organizations) or large institutions such as universities or hospitals. Their energy budgeting is typically influenced by three primary economic drivers: budget, procurement and price. For example, the Chief Financial Officer (CFO) of a major university might say, “I want to fix my costs now (budget), so I can issue and implement an annual financial plan with few surprises. On the other hand, I want to maximize market opportunities (price) and minimize my procurement costs (procurement).” Large private sector users can also take advantage of these strategies, but the need for budget stability tends to be more emphasized in public sector organizations.
Many energy risk management techniques are considered “financial hedges,” which are viable alternatives to negotiating fixed price contracts with suppliers in this high volatility market environment, effectively separating price and supply decisions. Financial hedging strategies are comprised of products, instruments and tailored credit terms for managing energy exposure. The commodities covered include natural gas, crude oil and petroleum products (propane, gasoline, diesel, heating oil, jet fuel and heavy fuel oil).
Energy Hedging Financial Instruments – and How to Use Them
Financial instruments to hedge risk for the use of those commodities include swaps, call options, put options and collars. Each is appropriate under different financial and market conditions in which the user of energy is operating. Following is a discussion of these energy risk management techniques, and the way they operate in the marketplace.
A swap is an agreement to exchange cash flows in the future according to a prearranged formula. This tool can be structured to provide a fixed price regardless of market volatility. When the market price is above the swap price, the energy user receives a cash payment. When the market price is below the swap price, the energy user makes a cash payment. As a result, if there is a strong possibility that market prices will drop, this may not be the strategy to deploy.
Call options insure against a price rising above a level by paying an upfront premium. Organizations usually implement this strategy when they expect market prices to rise. If market prices fall, they will lose the premium that was paid upfront.
A put insures against a price fall below a level by paying an upfront premium. Producers of energy typically request this financial instrument to prepare for the possibility that market prices can fall, and are typically used by oil and gas producers to guarantee cash flows.
A “collar” is when you buy a call, financed (partially or fully) by selling a put. This creates a price band and insures against prices rising above the call strike, in exchange for a loss of participation in prices below the put strike. In other words, the user won’t be at risk should prices rise above a certain price but they also won’t benefit if prices fall beneath a certain price, either. This works well for organizations that need price parameters to adhere to budgets but want to participate in market advantages, within those parameters.
For one Midwestern city, entering into a collar hedge made sense in the summer of 2007. As gasoline prices fluctuated, the city was able to stay within the set budgets for their firetrucks, police cars and other gasoline usage, but also benefited within their price parameters when gasoline costs fell at certain points during the term of the agreement. The city both saved the taxpayers money and had no sleepless nights regarding its ability to stay within the annual municipal budget when gas prices rose.
To Hedge or Not To Hedge?
At the end of the day, every large user of energy must evaluate the options available, and determine which, if any, of the energy hedging solutions are likely to result in a financially beneficial outcome for their organization. Some market trends to consider include the fact that the commodity markets, and in particular energy markets, are in a buoyant state. The structural shift that was seen in 2004-2005 has been reinforced in 2006-2007. This means that historically high hydrocarbon prices may be here to stay. At the same time, uncertainty in energy markets and tight supply/demand balances will continue to result in high price volatility.
To Market, To Market
In these market conditions, it is an emerging reality that fewer suppliers are wiling to offer fixed pricing due to market volatility than in years past. Putting a proactive energy risk management strategy in place through a trusted financial institution reduces the risk of counterparty default and lack of coverage both in terms of geography and product. It can also be a win-win solution to the challenge of participating in market upsides, while ensuring that runaway price volatility won’t create financial uncertainty that affects everyone in the utility supply chain.
About the Author: Andrew Fletcher, Senior Vice President Energy Risk Management, KeyBanc Capital Markets. Mr. Fletcher’s responsibilities include the marketing of Energy Derivatives to current and prospective clients. Fletcher has more than 21 years experience in the petroleum industry. Beginning his career with British Petroleum in London, he has significant experience in trading, hedging, and risk management techniques specific to the energy industry. At varying times in his career, Mr. Fletcher has been responsible for the creation, management, and operation of large trading books and refinery product lines. Mr. Fletcher holds a Bachelor’s Degree and Master’s Degree (1984) in International Business from the University of Manchester, Great Britain.