Price hedging : go long or go short?

Written by Bart Verest

“I think we should buy all of our electricity and gas needs for next year’s delivery because I’m risk averse and don’t want to miss this opportunity”. It’s a statement I’ve heard quite often in the past few years. Sometimes, it’s followed by the reaction of another stakeholder who, on his end, wants to “take some risk and leave volumes open on the spot market”.
This example brings two important risks to the surface when buying energy.

We often see that the personal definition of risk is equated with the definition of risk for the company. On one hand, you will have people who see volumes floating on the spot market as a risk because of the unpredictability of spot pricing. On the other hand, you will have people who argue that hedging forward volumes is a speculation on the future price evolution and that a buyer shouldn’t speculate on this. In themselves, both statements are incorrect. Whether or not hedging volumes / leaving volumes open on the spot market constitutes a risk depends on the business model of the company.

To explain this a bit further, I can take extremes on both sides of the spectrum as an example. On one side you have company A that makes long-term pricing arrangements with its clients. In order to do this, they look some three years ahead and estimate all costs to determine the final product price they will agree on. Their energy cost is naturally included as part of their calculations and therefore has to remain stable for the next years. If they end up with a price that is higher than the one they agreed upon, they lose margin. In this case, leaving (too much) volumes open on the spot market is rightfully considered a risk because it represents a mismatch between their pricing model and their business model. On the other side you have company B that meets every quarter with their clients to agree on a product price for the next quarter.

In these quarterly agreements they have clauses where they pass-through the energy cost. If they do price hedging for the next three years and the energy markets drop, they will lose margin as their clients force them to lower the prices they charge for their products. In this case, it’s buying (too much) volumes on the forward market that represents a mismatch between their business and pricing model.

Therefore, answering the question “go long or short” should have nothing to do with the personal convictions of the energy buyer regarding future prices or his/her appetite for risk. It should be based on a long-term energy buying strategy that aims to reduce the impact of energy market volatility on a company’s bottom line. In my presentation at this year’s “Transatlantic Energy Conference”, I will give practical examples of how companies from many different industries managed to take control over their energy costs by setting up such a strategy.

Missed our Transatlantic Energy Conference? Contact us to ask for the slides and/or have a look at the aftermovie.