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What the Oceans can Teach Us about Energy Hedging

I recently posted on energy management strategy with interruptible natural gas rates and the polar vortex as the backdrop. Over the last few weeks, I’ve received several emails asking for my thoughts on hedging, and I thought I’d put together a follow-up on the subject.

I think there’s a nice comparison between energy markets and oceans. I’ve used this analogy in conversations with those outside the energy field who asked what I do for a living and were interested (or just polite) enough to stick around for the long explanation. Like oceans, energy markets are expansive, strong and deep. And very interconnected. World powers are known to have tremendous influence on global energy markets, but even smaller countries can create a ripple that quickly radiates around the world under the right circumstances. The civil unrest in Ukraine is the latest example of this reality.

ocean_storm

With $30 billion (€21.8 billion) in energy spend under management, we pilot a very large ship on these waters. The largest in the world, actually. Our task is easier when there are no waves, but our expertise is most evident when the waves are all around us. Energy markets can be highly volatile and unpredictable. As we discussed previously, planning and preparation are critical.

As energy managers, we watch the markets constantly to gauge which way the wind is blowing today and look for signs to indicate which way it will blow tomorrow. We build contingency plans. We make provisions for multiple scenarios. We can’t eliminate market volatility, but we can advise our clients on ways to protect their companies from some of that volatility. A structured, strategic commodity hedging program is one such form of protection.

The principles of hedging can apply to any commodity, from copper to corn to cattle. A few of the most basic energy-related commodities are crude oil, gasoline, natural gas and heating oil. The basic idea behind an energy hedge is that a company locks in an energy contract to buy one or more components of a given commodity at a set price over a period of time. Hedging is less about savings than it is cost avoidance, budget certainty and risk mitigation. Naturally, clients are more apt to focus on risk when market volatility causes uncertainty, but the calm before the storm is the most advantageous time to consider installing safeguards.

To illustrate this idea, consider this historical volatility chart of NYMEX natural gas:

NYMEX_ng

Notice the recent four-year high comes on the heels of the four-year low. For natural gas, the end of 2013 was the calm before the storm both literally and figuratively. I was on a recent conference call with our team and one of our large industrial clients on the East Coast. Acting on our advice, this particular client put hedges in place for both the natural gas commodity and the transportation component heading into Q4 2013. Needless to say, that decision has paid huge dividends in significant cost avoidance. Hedging was the right strategy for this particular client.

However, hedging isn’t right for everyone, which is why our recommendations are never one-size-fits-all. We first seek to understand each client’s business decisions, how they operate and their current exposure to energy price risk. Working through this collaborative process with each client helps determine when hedging makes sense, and when it does, what tools and approach we should use.

We have been reminded this winter just how volatile and unpredictable both U.S. natural gas and electric power markets can be. The most effective hedging strategies were put in place months and even years ago in preparation for events just like these. With spring just around the corner, some relief is likely ahead. The relative calm may cause your organization to put off discussions on hedging strategies. I would advise against that decision. When you’re heading out to sea, it’s best to plan before the storm, not in it.

If you’re interested in discussing hedging strategies, we can help. Leave a comment below or click for more information

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Read my previous post on interruptible natural gas rates and the polar vortex.


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