When Is It a Good Time to Hedge?

November 2008

• Hedging produces a desired outcome with a high degree of predictability.
• Therefore, when risk is becoming greater than can be tolerated, it is time to hedge.

To answer the question about a good time to hedge, it is important to distinguish between hedging and speculating. Speculating is the process of taking positions with the goal of profiting from an anticipated change in market conditions. Therefore, speculating involves making decisions based on a market view, places more emphasis on market timing, and results in a financial gain if the bet is a winner (and a loss if the bet turns out to be a loser). Hedging is the process of taking positions that reduce risk. With hedging, an organization takes steps to achieve certain outcomes with a high degree of predictability. Hedging addresses an organization's concerns about the potential for unfavourable costs for its inputs, or operating expenses. For example, a school board or hospital will want to reduce the risk associated with fluctuating energy prices to enable it to remain within budget on the energy component of its operating costs. Hedging will address this concern; speculating will not.

Studies have shown that organizations that hedge tend to experience lower volatility in cash flows compared to organizations that hedge less or speculate. This observation has important consequences. For one, the lower volatility in cash flows facilitates the ability to devise budgets with greater certainty.

In general, any time is suitable for risk management. More specifically, it is time to hedge when an organization's risk tolerance level is close to being exceeded.

For many organizations, the distinction between speculating and hedging is sometimes blurred, and the question of trying to time the establishment of hedges is akin to an investor asking when is a suitable time to buy a stock with the hope of earning capital gains in the future. Few would consider the purchase of a stock for its potential to provide capital gains as a form of risk management. Yet organizations can become distracted and overlook the real purpose of the hedge; namely, as a risk management tool.

It is virtually impossible for energy buyers to know with confidence that they are getting the "best" possible price in advance. The chart below shows the forward strip price at AECO for the 2008 - 2009 gas year (November 1, 2008 to October 31, 2009) over the period November 1, 2003 to November 1, 2008.

(Source: NGX)

A forward - thinking purchasing manager may have considered buying gas at AECO for gas year 2008 - 2009 at any time leading up to November 1, 2008. However, the timing of the "best" (lowest) and "worst" (highest) prices occurred at different times over the years. With hindsight, the absolute "best" price since November 1, 2003 was on December 5, 2003. It may appear that the first half of the 2004 - 2005 and 2007 - 2008 gas years would have been an acceptable time to purchase the strip. In other gas years, the second half of the year would have been the best time to purchase the strip (e.g., gas years 2005 - 2006 and 2006 - 2007). Ultimately, no consistent pattern exists that demonstrates that there is a "best time of the year" to hedge.

Thus, it is prudent for purchasing managers to focus on what they can control and keep their organization's risk management focus clearly in view. Attempting to time the establishment of hedges (or engaging in speculation looking for the next "big win") can become a costly and frustrating exercise that is at odds with the long - term interests of an organization and its stakeholders.

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