Think of Hedging as Just an Umbrella for Unpredictable Weather

September 2013

• Deciding when to hedge should be as easy as deciding when to take an umbrella in the morning.
• Hedging some arbitrary percentage of our energy portfolio likely means that much of the time we will have too much hedged, and much of the time not enough hedged.
• We apply hedging in periods when we see a high enough probability of adverse conditions occurring, or when we have more to lose if they occur. This approach makes sense in our day-to-day lives, and it makes sense in energy hedging too.

Energy price risk management seems complicated. But deciding when to hedge should be as easy as deciding when to take an umbrella in the morning.

Energy buyers recognize that prices go up and prices go down. Hedging is a way to protect one’s organization from the negative impact of prices going up, but it comes with the opportunity cost that one misses out on the benefit when prices go down.

For this reason, some buyers will try to find a middle ground, something not as risky as being fully exposed to the market, but not as conservative as being fully hedged. For example, let’s hedge 60%!

But if we think about this carefully, we realize that hedging some arbitrary percentage of our portfolio likely means that much of the time we will have too much hedged, and much of the time not enough hedged. Only occasionally, and somewhat randomly, will the amount hedged be exactly right. Things may turn out alright on average, over the long run, but for given periods within that time frame, we may not be at all happy with our price experience.

Consider someone who enjoys walking to and from work each day. He does not want to get caught in the rain and ruin his wardrobe, and so he needs an umbrella to hedge against that risk. But lugging an umbrella around on a day without rain is irritating. Recognizing one can’t always be sure when it will rain and when it won’t, he decides to take his umbrella to work every Monday, Wednesday and Friday. Thus, he will be 60% hedged against getting wet.

Of course, there will still be rainy Tuesdays and Thursdays, and he’ll get wet those days. And there will be a few inconvenient Mondays, Wednesdays and Fridays when he will have a useless umbrella.  But, on balance, he’ll get wet less often than if he never took an umbrella. And taking an umbrella every day would be too much of an inconvenience.

But, of course, no one really hedges his “weather” risk this way.

Intuitively, we assess the probability of rain each day. Perhaps if there is a greater than 60% chance of rain today, we’ll take an umbrella. If we are dressed in our finest clothes, and have more to lose by getting wet, maybe our risk tolerance is lower, so we’ll take the umbrella in the face of a 40% chance of rain.

We apply hedging in periods when we see a high enough probability of adverse conditions occurring, or when we have more to lose if they occur. This approach makes sense in our day-to-day lives, and it makes sense in energy hedging too.

If market conditions are benign and prices are low and stable, hedging is like taking an umbrella on a fair weather day. It comes with a cost, and provides no benefit. If market conditions are threatening, or if an unexpected disturbance would impose an unacceptable cost, then a hedge is called for. The only tricky part is assessing the “probability of precipitation” in the energy market context.

Aegent solves this problem using an analytical tool called RiskSensor that provides a reliable assessment of the probability of certain price changes occurring over a given time frame. RiskSensor guides hedging decisions much the same way the “probability of precipitation” guides umbrella decisions. If the buyer knows with 90% confidence that unacceptable prices are not likely to occur in the next month, then there is no need to hedge. This helps the buyer avoid paying price premiums for unneeded hedges, and allows the buyer’s costs to decline with drops in the market. If the RiskSensor analysis shows the price risk is increasing to unacceptable levels, the buyer knows it’s time to seek cover.

While the RiskSensor model itself may involve some advanced math, the concept behind it is simple, and reflects the common sense we all apply in our everyday lives. Protect yourself when you need to, but only when you need to, since unneeded protection also has a cost.

With this simple approach to energy hedging, you’ll be home and dry.

Hedging: There’s a Better Way than Market Timing  Read more »