Hedging: There's a Better Way than Market Timing

May 2013

• The problem with market timing as a hedging philosophy is that time is never clear except in hindsight, and there is a cost associated with being wrong, whether the buyer is too soon or too late.
• The better way is to establish a price target for a forward period, and hedge only to the extent necessary to protect your ability to achieve your target price.

By historical standards, natural gas prices have been quite low for the last several months. While buyers who have had a large proportion of their supply moving with floating market prices have saved some money over the last couple of years, most buyers would expect prices to rise from these levels at some point. The question is, when to lock in to get the best price result?

While the winter of 2012-13 was closer to normal than the winter before, gas prices remained low until mid-March. When colder weather hung on tenaciously through late March and through April, when we should have seen more moderate temperatures, gas demand remained high, storage balances were drawn down, and gas prices rose noticeably – futures prices for 2014 were up 7% from March 5 to April 24.

This price rise was a bit of a surprise, as prices had been locked in a range for some time before that. The jump highlighted that the end of very low prices, when it comes, may come as a surprise. Should buyers expect the unexpected and lock in early?

On the other hand, when near term prices have been their lowest over the last several months, we have usually seen a steep forward curve. This is just another way of saying that prices for future periods have traded well above the discounted near term prices. So those buyers who do want to lock in early have had to lock in prices at a significant premium over current spot prices. If the low-price environment persists for longer, these buyers will end up having paid a premium.

And this is the problem with market timing. It’s obvious there is an optimum time to fix prices on volatile commodities like natural gas. The problem is, that time is never clear except in hindsight. And there is a cost associated with being wrong, whether the buyer is too soon or too late.

There is a better way.

Establish a price target for a forward period. This has to be a price that is at or above the current forward market (if it is below the current forward market, then you are setting a target that is beyond your control to achieve). Hedge only to the extent necessary to protect your ability to achieve that price. If prices are falling, or moving sideways, then hedging is not required, as your target is not threatened. If prices are rising, so that your ability to achieve your target is at risk, then you need to start hedging, to stop the rise in your expected price and preserve the ability to meet your target.

As you are driving down the highway, you establish for yourself a safe following distance behind the car ahead of you. If you are following at a significant distance, then the danger is a long way off, and you don’t need to brake every time they do. You will brake as necessary to ensure no damage occurs.

Market timers use a different approach. Those who hedge only once it is clear the market has jumped run the risk of reacting too late to avoid damage. Sometimes, they wait to see if the price move is for real. This is like not braking even though the car ahead of you has stopped, in the hopes it will get moving again before you hit it. Sometimes it works, but when it doesn’t work, the outcome is not good.

On the other hand, those who brake early, are hitting the brakes in case the car ahead might stop. This would seem to make sense only if the driver is very close to the danger point and doesn’t have sufficient reaction time to respond if danger should arise.

It is important to acknowledge that we cannot consistently time the market, and we should abandon market timing as a hedging philosophy. Instead, we should set reasonable targets and act rationally to control risk, applying the brakes smoothly and judiciously to keep unfavourable outcomes at a safe distance.

Is It Time to Lock in Prices for Natural Gas? Read more »