We've recently been engaged by a couple new clients which are going to be hedging their exposure to energy commodity prices for the first time in each company's history.  As such, prior to engaging us, neither of them had a formal energy hedging and/or risk management policy.  So, how does one develop an energy hedging policy from scratch?

Start by defining the purpose(s) of the policy.  As an example, the purpose of an oil and gas producer's hedging policy might read as follows:

• To ensure continuity of exploration and production in adverse market conditions
• To ensure that revenue and cash flow are sufficient to meet or exceed budget
• Seek opportunities to increase revenue and cash flow, while reducing risk, by restructuring or liquidating existing hedge positions. 

As another example, an industrial consumer's (manufacturing, processing, etc) purpose might read along the lines of the following:

• To mitigate our exposure to volatile and potentially rising diesel fuel and natural gas prices
• To ensure that our diesel fuel and natural gas costs remain within budget and predictable
• To guarantee that our exposure to diesel fuel and natural gas price volatility is not a factor that could put us at a competitive disadvantage

Next define the who, what,  how, why and when...

Who is going to be responsible for ensuring that the company follows the policy and what checks and balances need to exist?  

Who is responsible for developing, implementing and managing the hedging strategy(s)?  A hedge committee, CFO, third-party consultant?  Do they need additional, internal or external resources?

What transaction type (i.e. futures, swaps, options, etc), volume, tenor (time frame) and financial exposure (gross and net) are within the company's risk tolerance? 

How will financial exposure be measured and by whom?  VaR, CFaR (cash flow at risk), another metric of some sort?

When will the first trade be executed and why?  When and how will the positions be reviewed to ensure that they are still appropriate given the company's risk tolerance, hedging policy and market conditions?

Who is responsible for executing trades? 

Who is responsible for FCM (futures commission merchant) and/or counterparty selection and approval and what criteria will be used to evaluate FCMs and counterparties?  What about monitoring counterparty credit exposure? 

Who is responsible for position reporting?  What are they to report, how often and to whom?

Clearly there are a lot of issues to be explored when developing an energy hedging and/or risk management policy but hopefully this provides a good understanding of the types of questions that need to be asked and answered when developing a hedging policy.  If you need assistance developing your company's energy hedging policy please don't hesitate to contact us.