A Market Timing Strategy Won't Minimize Price

November 2008

• Locking in when the market reaches a low price target neither controls risk nor minimizes price.
• A better strategy involves being conservative when high prices threaten, while remaining aggressive when the risk of extreme prices is small.

"When it drops to $7.00, then I'll lock in". Energy buyers who pursue a strategy like this are trying to manage risk by locking in a price that they perceive will turn out to be lower than prices in the future. And they are trying to minimize cost by waiting for the market to fall as far as possible before they lock in. Ideally, they want to lock in at the bottom. That's the goal of all market timing strategies!

But, gas prices are notoriously volatile. They can change direction dramatically, without warning and certainly without regard for any arbitrary target a buyer may have in mind. What happens to the buyer with a $7.00 trigger price if the market declines to $7.05 and then reverses and rises to $10.00? Pursuing that last nickel of gas cost savings has ended up costing almost $3.00!

And what about the buyer who locks in at $7.00, only to see the market subsequently fall to $6.00? They've left $1.00 on the table.

In fact, if you think about how this strategy would play out in the long run, locking when the market hits a low price target neither controls risk nor minimizes price. If the market never reaches down to the target, the buyer remains fully exposed no matter how high prices go. That's not risk management.

And if the buyer locks in a price as the market is falling, he cuts off his chances of paying the lowest prices. That won't minimize price.

In short, this strategy ensures the buyer will always pay the highest prices experienced in the market, but will never pay the lowest ones.

There is a different strategy that works better. It is a strategy that involves being conservative when high prices threaten, while remaining aggressive when the risk of extreme prices is small. If your organization cannot afford to pay a price above $10.00 for gas, then when prices are rising to the point where $10.00 is a strong possibility, you need to be locking in portions of your gas requirements. By the time prices reach $10.00, you will have long ago locked in at an average price below that.

Prices are cyclical and they will fall again. All fixed price deals come to an end. When your fixed price terms have expired and the market is falling and moving away from $10.00, there is no need to lock in prices. The risk is distant, and receding, so there is no need to take action.

Under this strategy, the buyer is free to enjoy the lowest prices experienced in the market, and will never be unhedged when high prices hit. Isn't that how you want to buy gas?

To make this strategy even more effective, Aegent offers RiskSensor©, which can quantify the likelihood of future gas price movements. So, for example, if a buyer wants to be 90% certain that their cost of gas for 2009 will not exceed $10.00, RiskSensor can tell them when it is necessary to lock in price, and how much to lock in. This gives buyers the confidence to control risk and minimize price.

What is the cost of managing energy price risk? Read more »

Develop a "SMART" goal for your energy procurement plan. Read more »