What is the Cost of Managing Energy Price Risk?

October 2008

We often say that cost reduction and risk reduction are at opposite ends of a spectrum when it comes to energy buying. This implies that risk reduction costs something ... you can't reduce risk without sacrificing something on a cost reduction basis. Is this true? What is the cost of energy price risk management?

To answer this question, we defined the cost of risk management as the average premium of fixed price gas over indexed price gas. Fixing a price controls a buyer's risk (price uncertainty), but does the buyer pay more, on average, by fixing his price, and if so, how much more?

The answer, at least over the last five years, is YES, buyers of fixed price gas do pay more and about 5-6% more - a premium of about 35 cents per GJ on average.

From day-to-day, gas sellers offer buyers a forward price for gas. In October 2008, we can "buy forward" and lock in our price for all of the gas year from November 1, 2008 to October 31, 2009. Or, we can just take a floating price and the price we pay will depend on the market's ups and downs over the next year.

For our analysis, we compared forward prices for each of the last five gas years (2003-04 to 2007-08) to the average AECO monthly index price for the gas year. The forward price for the 2003-04 gas year was the price being offered by marketers during the period from November 2002 to October 2003 for gas to be delivered between November 2003 and October 2004. Did buyers who consistently "bought forward" pay more than they would have paid on a floating price?

Fixing a forward price can be done at any time, and it's not possible to analyse all the possibilities so we made a few simplifying assumptions:

1. The buyer would fix prices some time in the 12 months prior to the start of the gas year (some buyers hedge further ahead than that, but most don't).
2. The buyer could buy 1/4 of his portfolio on each of Jan 1, April 1, July 1, and Oct 1 prior to the start of the gas year. The resulting portfolio price would be the average of the four purchases. This assumption avoids a bias in deciding when a buyer would buy.
3. Alternatively, the buyer could pick any day in the year at random to buy the next year's gas. If we have enough people picking days at random (out of a hat, say), then all of the days would be picked in equal proportion, so the result is just the average forward price over the 12 months leading up to the start of the gas year.

What we found - no surprise -- is that some years the fixed price strategy was a winner and some it was a loser. But over the last five years, the strategy of fixing a price resulted in a higher average cost of gas by about 35 cents per GJ. This result was the same whether the buyer bought on random days or bought 1/4 of his requirements at the start of each quarter. (This finding supports Aegent's coin flip analogy.) On average over the five years, fixing a gas price every year cost a buyer about 5.5% more than just allowing it to float.

While this analysis looks at the cost of hedging, it does not look at the benefit. In some of the years studied the highest monthly index price was more than twice the average price for the year, so a buyer would have to have sufficient cash on hand to withstand that volatility if buying on index, whereas that anxiety is taken away for a buyer on fixed prices.

For some buyers, the added cost of fixed price gas can be justified as a reasonable cost to obtain price certainty and avoid the risk that prices would rise to a level the organization could not sustain. But the analysis shows that risk management does have a cost. One way to minimize that cost would be to fix only a portion of the total gas portfolio, with that portion based on achieving the desired risk control outcome. A tool such as Aegent's RiskSensor© model is ideal for this purpose.

Obviously, gas market price cycles affect the outcome of this analysis, so a valid analysis has to look over many years, and ideally many price cycles. Taking one or two years in isolation would give a false picture.

For additional information about how Aegent Energy Advisors can help you manage your energy price risk, contact John Voss at jvoss@aegent.ca.