Unintended Consequences: The Impact of Overhedging

June 2010

• Hedging involves entering into a transaction that reduces your organization's sensitivity to market prices, and therefore reduces risk. Overhedging results when the total quantity of hedge entered into is greater than the net price exposure you had to begin with.
• The electricity market in Ontario is one example where overhedging is a significant risk that not enough buyers realize. If consumers enter into electricity contracts to fix a price without first understanding the significant hedging effect of the Global Adjustment, the result could easily be an overhedged situation.
• Since the Global Adjustment provides a hedge effect that takes away almost 85% of an average consumer's price risk, only the most risk averse buyers may have a need to hedge.

Many businesses and institutions that use commodities in their operations employ hedging as a means to control the risk of fluctuating commodity prices. Hedging involves entering into a transaction that reduces your organization's sensitivity to market prices, and therefore reduces risk. Transactions that increase sensitivity to market prices and create more risk could be considered 'speculative'.

Without a hedge, your costs rise dollar for dollar with a rise in the price of the commodities you buy. If you are 100% hedged, your cost is fixed regardless of the movement in the price of the underlying commodity.

Where you need to be on this spectrum depends on the business you are in, and how much you can absorb the cost of commodity price swings. But what if you noticed that your commodity costs (net the cost of your hedge) were going UP while the market price of the commodity you buy was going DOWN? This is certainly not a normal state of affairs for a buyer. This is an indicator that you may be 'overhedged'.

Overhedging results when the total quantity of hedge entered into is greater than the net price exposure you had to begin with.

Imagine a division manager in a company that hedges his exposure to the exchange rate between Canadian and US dollars because his division buys a lot of its inputs in the US. His goal is to reduce risk for the benefit of his company. He may be unaware that another division of the company sells a lot of materials into the US, and gets paid in US dollars. The exchange rate exposure of the two divisions offset one another to some degree and the company's net exposure to the exchange rate is lower than it appears to either division manager. If one division manager hedges his total exposure, he has overhedged the company. The company's earnings will be more sensitive to exchange rate fluctuations than they were before the hedge. The company has taken on risk, rather than reducing it. Some surprises may be in store for the CFO.

Overhedging in Electricity Procurement

Sometimes an organization's net exposure to variations in the price of a certain commodity is not simple to determine. The electricity market in Ontario is one example where overhedging is a significant risk that not enough buyers realize.

The Global Adjustment is a cost mechanism in the Ontario electricity market that either debits or credits consumers each month to adjust for the difference between the market price and the value of price guarantees that have been provided to certain generators. The impact of the Global Adjustment on consumers is very much the same as a price hedge on a large proportion of their electricity consumption. If consumers enter into electricity contracts to fix a price without first understanding the significant hedging effect of the Global Adjustment, the result could easily be an overhedged situation.

Remember, when a buyer is overhedged, their net costs go up as the commodity price goes down. That's a sobering thought to consumers given the way in which electricity prices have declined over the past year, due to weak demand and growing supply.

The operation of the Global Adjustment is complex, and not at all transparent. In Aegent's view, the hedging effect of the Global Adjustment is likely greater than most consumers realize.

Backward-Looking Example

To illustrate this risk with real numbers, let's assume a buyer entered into a fixed price hedge for electricity in April 2009 for a one year period from May 2009 to April 2010. Given the actual behaviour of market prices and the Global Adjustment values each month over this period, let's see what the impact would be for 3 different hedge quantities. Specifically, we looked at how the consumer's net cost of power (the sum of the spot price + Global Adjustment + hedge impact) varied during the term of the deal as average Hourly Ontario Energy Prices (HOEP) changed each month, over the range of HOEP seen during the period. All of the hedges are entered into at the same price. The change in impact is due only to the amount hedged.

Aegent is of the view that a reasonable analysis in April 2009 would have pointed to a hedge of about 22% of one's energy consumption as the amount needed to be essentially fully hedged. The other 78% of one's price risk was expected to be covered by the hedge effect of the Global Adjustment.

In addition to the 22% case, we looked at what the impact on net cost of power would have been if one had hedged 12% or 32% of their load. For all 3 cases, we assumed the consumer entered into a hedge at $37/MWh, the going forward price for 7x24 power in April 2009. To see the results, click here.

For the hedge of 12%, the line that relates net cost to HOEP slopes up to the right. When HOEP was higher, the consumer's net cost was higher. This makes sense, as we expected that hedging only 12% meant that part of the exposure was unhedged. As a result, we would see higher costs when prices rose, and lower costs when they fell. However, the slope is not steep, reflecting the fact that a 12% hedge together with the impact of the Global Adjustment together eliminated most of the price sensitivity of the consumer's costs.

In the case of hedging 32%, we see the line slopes down to the right. In this case, net power costs are lower as prices rise and higher as prices fall. This is perverse cost behaviour. It shows that this level of hedge together with the hedge effect provided by the Global Adjustment resulted in an overhedge.

Even the expected optimum hedge of 22% shows a slightly down-sloping line, reflecting that even hedging 22% was too much. Changes that evolved in the Global Adjustment over the one-year term meant that the hedge effect was greater than might have been anticipated in April 2009, and consumers faced even less price sensitivity in their costs than was apparent at the time. In fact, the degree of hedge that produces a flat line (a net fully hedged position) is about 17%.

Implications

It pays to understand the intricacies of the Global Adjustment, particularly the degree of the hedging effect it imposes on all consumers. Even in-depth analysis of the Global Adjustment will not reveal all of its secrets, since changes can happen over future months based on initiatives and decisions that are not yet public.

Since the Global Adjustment provides a hedge effect that takes away almost 85% of an average consumer's price risk, only the most risk averse buyers may have a need to hedge. Taking into account the lack of transparency in the Global Adjustment, and the low price risk, any hedging that is undertaken should be conservatively low in the amount hedged, to ensure one does not end up overhedged. An overhedged position increases the impact of price changes, rather than decreasing that effect.

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