Since the NYMEX introduced the heating oil futures contract in 1978, energy consumers, producers, marketers, refiners and processors have had the ability to hedge their exposure to volatile oil and gas prices. However, for many companies, hedging can cause as many challenges as solutions.   The key to developing a successful energy hedging program is to develop a sound plan and stick with it.  By following these six key steps you should be able to develop, implement and manage a successful energy hedging program.

• Identify, Analyze and Quantify Your Market Related Risks

• Develop an Official Hedging Policy

All market risks should be addressed through a process that establishes risk management goals and objectives as well as risk tolerance. This should be formalized through a hedging policy which explains your hedging objectives, goals, risk tolerance and approved hedging strategies in order to clearly define the decision-making process and determine responsibility for each step of the hedging process i.e. pre-trade analysis, trade execution, financial reporting, etc.  The hedging policy should be approved by the board of directors and/or management team.

• Controls and Procedures

A hedging policy needs to be supported by controls and procedures that ensure hedging activities receive an appropriate level of attention and oversight, such as the proper execution and reporting of trades. A poor but well implemented hedging policy is often superior to a sound but poorly implemented hedging policy. That being said, there is simply no excuse for not having a sound hedging policy. 

• Implementation of Hedging Strategy

Once you’ve completed the first three steps you should be able to begin implementing your initial hedging strategy(s).  For most companies, implementation and management of the hedging program should be a consistent, dynamic process, as opposed to a static process.  As such, your hedge positions need to be properly analyzed on a regular basis and if applicable, optimized if and/or when your goals, objectives and/or market conditions change.

• Monitoring, Analyzing and Reporting Risk

All risks related to hedging need to be continuously monitored, measured and reported through the company's hedging “framework”. As the company's risk exposure changes, there should be a systematic process for reporting and determining if the hedging policy or strategies need to change or if the existing policy and strategies remain sound.  If a change in policy or strategy needs to occur, the change should be preceded by proper analysis and discussion, not a spur of the moment decision.

• Repeat

While the five previous elements should be the primary building blocks of your hedging program, the "last" step is the most important: repeating the entire process as often as is necessary.  While your formal hedging policy may only materially change once every year or two, the other steps should become a standard process that occurs on a regular basis, depending on your company’s specific needs.  For companies with very active hedging programs this could be as often as a daily, while companies with more “basic” hedging programs may only need to go through the process as infrequent as once a month or  quarter.