To hedge or not to hedge, that is the question

By Benedict De Meulemeester

By Benedict De Meulemeester on 16/05/2009

It is a word that we use daily in our profession, 'hedging'. Therefore it is strange that many people seem to lack understanding of what it means. Often people confuse hedging with speculative behavior. I believe this is due to the association with the word 'hedge fund', that part of the financial industry which is considered by many to be extremely speculative. Hedging itself is considered to be an activity where profit maximization goes hand in hand with taking huge risks. Hedging to me has everything to do with the expression 'hedge your bets'. Take positions so that whatever direction the market takes, you never lose everything. The counterside to hedging is that it also means that you foresake the chance of maximum succes. As such, hedging is the exact opposite of speculation.

Last Friday, I had an interesting discussion with a client with a US mother company. Like many other American companies, this company also expressed its reluctance to apply hedging. In buying energy, there is a tendency among US companies to opt for spot price contracts instead of fixing prices. Price fixings are considered to be hedges and these are undesirable. This allergy to hedging is probably due to financial regulation which makes publicly traded companies publicize figures on the mark-to-market of their hedges. This means that if such a company has fixed prices, and the price has fallen since, it will have to report a loss on hedging positions in its financial reports. That explains of course why companies are afraid of energy price hedgings. They want to avoid reporting such losses on hedges, fearing the reactions of shareholders.

In a way, a contract where the actual price is the result of averaging spot prices, is a way of hedging in itself. It means that you always pay the average price, never the highest and never the lowest. As such, it might be considered as the only possibility for non-speculative behavior in the energy markets. The trouble with it is the high volatility in spot energy markets (especially electricity). Consumers buying at spot prices will see their budgets rise and fall rapidly. And for many companies, this is incompatible with the desire to have some visibility on energy budgets. 

Most industrial companies do not want to end the year with an electricity or natural gas that is twice or even thrice as high as the budget that they had filed at the beginning of that year. And those responsible for buying that energy do not want to explain to their superiors that this derailing of the energy budget is due to the winter weather conditions, or the absence of wind during the fall, or the technical failures in French nuclear facilities, etc. To avoid this budget uncertainty, companies will have to enter into some sort of hedging. The nice thing about European energy markets is that most suppliers offer contract types that allow for price hedging without the difficulties regarding accounting. These could be multi-click contracts or more advanced products with caps, floors or collars. Even the simple fixed price contract is a kind of hedging contract. The nice thing about them, is that the futures, forwards or options that need to be obtained to deliver on them, go into the books of the supplier and not into the books of the client. As such the client can avoid the mark-to-market issues that public US companies fear.

This brings me to my discussion on Thursday with a German client. Like many in his country, he has no experience yet with multi-click contracts. So far he has entered into fix price contracts for longer periods. As the market in the past years was mostly bullish, they didn't do to bad with this, seeing that the prices that they had fixed were mostly lower than the current prices (or had a positive mark-to-market).  Nevertheless, there are some serious downsides to this approach. First of all, with such an approach you will see serious jumps in the budget of one year compared to the previous year. Secondly, sooner or later they will end up on the wrong side of the market, having been obliged to fix at a high rate and see prices fall afterwards. This could be because they have waited too long in a bullish market. Another pitfall has been witnessed by many in June 2008, at the highest point of the energy prices bull rally. Having waited for a long period before fixing anything, there is a large risk for panic at such record levels.  The multi-click contract is a perfect remedy for this. By fixing prices for parts of the yearly volume, one avoids having fixed too much at the wrong moment. By fixing prices for several years into the future at the same moment, the budget swings from year to year can be moderated.

This is probably the reason why this contract type is so popular among industrial consumers in many countries. I have seen many people that were extremely happy with having fixed the price of a large volume in one moment (through a fix price contract). They had fixed at low levels and were happy to have seen prices rise afterwards. If they were intelligent, they realized that luck was a larger contributing factor in such successes than skill. And this is proven by the fact that I have also seen people extremely dissatisfied with large volume price fixings, up to the point of getting fired for fixing at the wrong moment. By entering into a multi-click contract and then applying an intelligent spread strategy, one can avoid these emotional extremes. Therefore, I have rarily seen anyone dissatisfied with this approach.

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