Under the Influence of Last Winter's Memories?

October 2014

• Bad memories of last winter have led many buyers to lock up the price on a large proportion of their winter gas supply. But is this the prudent thing to do?
• Risk management costs money, so buyers should do only as much of it as they need to do.
• To deal with uncertainty about where this winter’s prices will go, start by asking how much price risk your organization can afford to take.

We know from experience that people remember best what they experienced last. Research has shown that this “recency bias” affects the way people make decisions. They tend to make decisions using assumptions about the future based on what has happened most recently in the past.

Last winter’s extreme weather had a significant impact on gas prices in many regions of North America. Sudden gas price volatility surprised many buyers, whose expectations had been set by several recent years of declining prices with very low volatility. As we head into another winter, bad memories of last winter have led many buyers to lock up the price on a large proportion of their winter gas supply. But is it prudent to do this year what you wished you had done last year?

Buyers understand very well that the market can deliver unpleasant surprises when prices turn out to be much higher than expected. But the market can surprise in the opposite direction as well. In March 2014, after the market had been beaten up all winter, gas for the summer months was offered for about $4.45/GJ at the AECO/NIT trading point. By the end of that summer period, we see that the actual average price over the period will be closer to $4.00/GJ.

The difference in prices amounts to tens of thousands of dollars for buyers with even a modest volume.

From our vantage point in March, the market could have gone two ways – storage was very low and demand to refill storage could have made prices strong. On the other hand, success in filling storage would moderate prices. In the end, the second scenario prevailed. Those who locked in the summer last spring to be conservative spent more than they needed to.

With the coming winter on our doorstep, two scenarios again present themselves. We are still a little short of an ideal storage inventory. Cold weather will strain this storage inventory and could lead to higher prices. On the other hand, a mild start to winter will help to erase the storage deficit by reducing early-season demand for storage, and would likely moderate prices.

One could say it all comes down to weather, and there is no way to guess which scenario will prevail. This quandary illustrates why it isn't useful to base risk management strategy on a market view. If we remember anything from recent experience, last fall and last spring should remind us that prices often end up very different from what is generally expected.

Hedging is not a tool for cost reduction, it is a tool for risk reduction. The objective of locking in price is not to beat the market, it is to prevent unacceptable outcomes. But risk management costs money, so buyers should do only as much of it as they need to do.

To deal with uncertainty about where this winter’s prices will go, start by asking how much price risk your organization can afford to take. What price level is tolerable? If the market rises toward that level in the coming months, be prepared to take incremental hedging positions to put the brakes before your cost exceeds your risk limit. Don't sit idle, betting (hoping?) that prices will subside. If prices decline, your risk is decreasing and you can afford to let that price decline continue without trying to guess “the bottom”. Locking in price in a falling market simply prevents your costs from declining further!

Aegent applies analytical methods to quantify these kinds of decisions for clients, but the basis of an effective risk management philosophy is to realize it is not about market view. By taking this different approach, buyers will be better served when they know what their gas cost risk limit is and hedge only as much as they need to in order to stay within that limit.

Hedging: A Tool for Risk Reduction, Not Cost Reduction Read more »