Buying to Control Price Risk

May 2010

• Decisions about locking in energy prices should not be driven by whether the market price is high or low, but whether the price risk is too high relative to the buyer's risk tolerance.
• Trying to save money by locking in at the bottom can cost money.
• Fixing price as a tool for risk management generally involves paying a price or risk premium. If managing risk costs money, it makes sense to buy only as much risk management as one needs. Buying portions of one's needs as the market rises toward a risk limit is a rational way to do this.

Aegent has long emphasized to clients that locking in energy prices is a strategy for risk management, not a strategy for cost minimization. For this reason, decisions on entering into fixed price arrangements should not be driven by whether the market price is high or low, but whether the price risk is too high relative to the buyer's risk tolerance.

When spot prices are low, as they are now, buyers are tempted to lock in prices for forward periods, as there is a sense that "we are at the bottom", or at least close to it. Certainly, current spot prices are low. The near-month NYMEX price is hovering around US$4.00/MMBtu. But the forward price curve is relatively steep. Prices for one year from November 2010 at NYMEX are US$5.13/MMBtu (a 27% premium to the near-month price) and for one year from November 2011, they are US$5.65/MMBtu (a 40% premium to the near-month price).

As we move forward in time, prices for those forward periods may rise, or they may fall.

Locking in your gas requirements at these prices means locking in a significant increase over the current conditions. It also means eliminating the possibility of paying $5.00, or $4.50 or even $4.00 or less for gas next year. But surely there is a chance the market could go there.

Let's turn back the clock a few months to September 2009. On September 3, 2009, the near-month NYMEX price set a 7-year low at US$2.508/MMBtu. At that time, the price for summer 2010 was $5.19, one year from November 2010 was trading for $6.25, and one year from November 2011 was trading for $6.58. September 2009 was a market bottom. Since that time, near-month prices have risen...but forward prices have declined.

This price experience shows why trying to save money by locking in at the bottom can cost you money instead. Buyers who locked in forward prices at September's market bottom eliminated the opportunity for forward prices to continue their decline. One year from November 2010 is now 18% cheaper than it was last September.

What's a better way to do it? Fixing your price is like applying the brakes in your car. You don't do that when you are a long way from any danger, or when you are moving away from a source of danger. You do it when you are approaching danger, and before you reach it.

Start by defining your risk tolerance so you know what danger looks like. What price can you live with? If you've set a budget for 2011, what is it, and what amount of budget overrun can you absorb if one occurs?

Let's say this exercise leads you to identify $6.00 as the price you do not want to exceed for 2011. The market is currently well below $6.00 for 2011, so as long as the 2011 price stays where it is or moves lower, there is no reason to lock in any gas for 2011. This strategy means you can exploit lower costs if forward prices decline as they get nearer. Even small market bumps up, such as we saw in mid-May, are not necessarily causes for concern. However, if gas prices start to climb with warm summer weather or a stronger economy, a wise buyer would start to fix prices on a portion of his supply as the market rises, and before it reaches the buyer's $6.00 limit.

Locking in 25% of one's supply at $5.50 means the buyer could average about $6.15 on the rest, and still meet a budget of $6.00 overall. It also means the buyer still has 75% open to benefit if the market rise was a false indication and the market starts to decline again.

If the market continues to rise, a second 25% portion of the buyer's needs could be purchased around $5.75. This further reduces the buyer's exposure to the risk of paying more than $6.00, as the buyer is exposed to only 50% of any further increases. The market would have to go over $6.35 before the buyer would be approaching the budget value of $6.00. If the market declines, or even goes sideways, the buyer is still below the budget cost, and benefits from lower costs as the market declines.

Buying in 25% portions is arbitrary. Aegent's RiskSensor model is specifically designed to determine the optimal proportion to buy based on current market prices and volatility, the buyer's risk tolerance, and the buyer's organizational decision processes and "reaction time".

Fixing price as a tool for risk management generally involves paying a price premium (call it a risk premium). If managing risk costs money, it makes sense to buy only as much risk management as one needs. Buying portions of one's needs as the market rises toward a risk limit is a rational way to do this. While it may be rational, it is somewhat rare. Most buyers are reluctant to buy in a rising market, fearful that the market will turn lower and they'll be left to regret their purchase. This is "market timing" thinking not "risk management" thinking.

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