The Hidden Opportunity Cost of Hedging

October 2013

• Many energy buyers need a high degree of energy price certainty and so they pursue a strategy of regularly locking in pricing on some or all of their supply for forward periods.
• The problem here is that locking in an arbitrary proportion of one’s portfolio in case prices rise is an inefficient way to manage the risk of energy market uncertainty. And because it is inefficient, it is expensive.
• The solution is for the energy buyer to tackle the risk management problem in a new way, assessing risk dynamically and applying only as much hedging as is required.

Are you among the many energy buyers who are over-paying for energy as a consequence of an overly defensive price hedging strategy? Risk management costs money, and so too much risk management costs too much.

Many energy buyers need a high degree of energy price certainty, and to get that, they pursue a strategy of regularly locking in pricing on some or all of their supply for forward periods. They often put some effort into thinking about exactly how much to hedge, or when the perfect time to hedge is, but the basic plan is to hedge in case prices rise. When prices fall instead, they end up paying more than they could have paid. That “opportunity cost” is a real dollar cost, as it represents dollars that could have been saved, or dollars that could have been spent elsewhere for productive purposes.

In 2008, gas prices rose sharply to the equivalent of 45 cents per cubic metre. By early 2009 they had subsided to the 30-35 cent range, a price perceived by many to be the “return to normal”. Many public buyers locked in these 30-something prices – often for as long as 5 years – to avoid the risk of a return to 45 cents. However, prices continued to decline, and spent most of the last few years in the 12-14 cent range. As a consequence, these buyers left millions on the table in gas “opportunity cost”.

It is fair to say that it was impossible to know for sure that prices would continue to fall, and buyers had to protect themselves against another increase. Far from us to suggest that anyone should be expected to have perfect foresight on what the market is going to do!

The problem here is that locking in an arbitrary proportion of one’s portfolio in case prices rise is an inefficient way to manage the risk of energy market uncertainty. And because it is inefficient, it is expensive. It is expensive when it results in not enough hedging, because energy costs rise above budget. And it is expensive when it results in too much hedging, because of the opportunity cost when you could have paid less. And what is most important to realize is that it almost always results in one of those outcomes or the other!

The solution is for the energy buyer to tackle the risk management problem in a more sophisticated way – the way large energy traders and banks manage risk. That is to assess risk dynamically and apply only as much hedging as is required in the circumstances to achieve the desired cost outcome with a known degree of confidence. The analytical techniques that Aegent calls RiskSensor allow clients to assess their portfolio relative to market conditions, and evaluate whether they are adequately hedged to protect their cost objectives, or whether more hedging is needed in the circumstances. Hedging only as much as necessary allows the portfolio cost to decline as much as possible if the market continues to decline, while applying hedges to protect the budget if market conditions are likely to put pressure on the budget.

Risk management costs money, and so you only want as much of it as you really need. To hedge efficiently requires looking at the problem in a new way, and bringing more sophisticated tools and insights to bear.

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