The Case For Developing An Effective Energy Hedging Program

The argument for developing an effective energy hedging program has never been more compelling. As the following data shows (NYMEX and ICE futures), energy prices have been incredibly volatile over the past few years, with highs and lows varying by as much as a factor of six and a half in the case of natural gas. 

This volatility necessitates that companies with significant energy price exposure develop a disciplined energy hedging program.  The penalty for executed hedging decisions can be painful or worse. In recent years we have observed numerous companies fail or suffer significant losses as a direct result of the misapplication of energy hedging instruments as part of an ill-conceived hedging program (i.e. Semgroup).

Equally worrisome is the decision by some companies to abandon their hedging programs all together (i.e. US Airways). There's no questions that developing and managing an energy hedging program can be challenging, especially given the recent and current state of the financial markets and regulatory uncertainty, but it can't be debated that a sound hedging program protects companies from excessive exposure to energy price volatility. An effective energy hedging program can provide several key, strategic objectives:

Reduces the risk of unexpected losses:

• Hedging losses are offset by lower energy commodity expenses, so a perceived loss is actually an opportunity cost.

• Losses on unhedged energy commodities are not offset, thus they have a direct, negative, economic impact.

Provides budget certainty:

• An effective energy hedging program provides budget certainty that can't be obtained otherwise.

Allows management to focus on core business:

• Management knows that exposure to volatile energy prices is being managed on a proactive basis.
• Cash flow stability, with respect to energy commodity expenditures (in the case of a consumer) or energy commodity revenues (in the case of a producer), can facilitate improved long term planning.

The ability to hedge is a key tool available to management of energy producing and consuming companies. By following a disciplined risk management framework and sticking to strategies that management understands and is able to clearly communicate to key stakeholders, hedging does not have to be a source of confusion or uncertainty, quite the opposite in fact.