You often hear people say, “It’s better to be lucky than good.” I go the exact opposite direction – Luck has the ability to hide bad management decisions. Going one-step further, bad decisions which lead to good results are often failures of management. This rings very true in the energy industry and is especially common when it comes to hedging decisions.
Luck, as defined by Merriam Webster’s dictionary, is the things that happen to a person because of chance: the accidental way things happen without planning.
Breaking the definition of luck into its parts…
First, there is no reference to positive or negative outcomes. Luck has no bias for positive or negative outcomes. There is no reason to believe your luck will be either good or bad. Second, it describes things as happening because of chance, or without observable cause. For purposes of hedging, we can roughly translate chance into probability. You cannot know when something will happen, but you know there is a statistical probability one of a certain number of things will happen. Finally, luck is accidental, things don’t always occur according to your plan. This is a very important part of the equation to remember for those tasked with managing energy price risk. It sums up quite nicely the entire reason for hedging – you don’t know what will happen or when it will happen and can’t control the impact it will have on your business.
Last year at this time, many market participants, both producers and consumers, rejected the idea of hedging because prices were high. Would you say luck was on their side? It depends on whom you ask.
For the months leading up to the drastic decline in oil prices, one could argue that producers were lucky. They did not control the price of oil, but benefited from ~$100/BBL. Producers were enjoying the party. As the party ends, many times so does the fun, as we found out last fall. When things are going extremely well, that’s precisely when you should be asking yourself the important questions. Chiefly, how can I protect our strong cash flows or wide margins? What about consumers? Some consumers made a conscious decision to remain unhedged, as did many producers. In the case of consumers, luck has been on their side as their costs have dropped dramatically over the last year. It is funny how luck has a way of masking bad decisions. How would higher prices have impacted consumers had prices spiked rather than collapsed?
Either way, the rule is the same for consumers as producers: proper analytics will articulate your risk in a way that allows you to make informed hedging decisions. More often than not, the pre-trade and post-trade analysis is more important than the trade itself. After big moves in the market, your strategy might evolve, but it’s important to stay the course. Hedging by definition is taking steps to protect against market movements that you cannot predict with any meaningful accuracy. Translation: Take as much luck out of the equation as possible. Luck can be good or bad. Bad luck tends to cause more harm and is often very difficult to bounce back from, at least in the short to medium term.
We encourage all of our clients to analyze their portfolios and operations to produce a quantified view of how changing market conditions might affect (positively and negatively) their corporate strategies including their hedging strategies. The output of a thorough analysis of your risk allows you to reach informed hedging decisions, decisions based on the risk inherent in your operations, NOT based on your view of the market. It also helps you to understand how much capital you should set aside for things like option premiums.
Some fuel consumers are scoffing at the idea that they made a good hedging decision last year because they are sitting on large losses. This is an important time to analyze your process. What decisions did you make that have led to the unsatisfactory losses? Did you utilize hedging strategies and products based on current (2014) market conditions or were you relying on “old school” conceptions about the energy markets? Losses aren’t unavoidable, but they can be minimized by using the right tools.
If you perform “what if” scenario exercises that exaggerate price moves to see how they will affect your hedging strategies you will be able to make much better informed hedging decisions. Then ask yourself, if prices increase or decrease by X%, can I accept how said changes will impact my hedge portfolio and my business? Asking these questions before you execute a trade will help you determine which strategies are best for your specific needs and objectives. Sometimes, the process will lead you to questions as specific as, “should I buy options or swaps?” No matter what your circumstance, performing the analysis will help you to understand the potential consequences of various hedging strategies. Many times the analysis will shine a light on flaws in your hypothesis and will help you avoid costly mistakes.
How do you know when it is appropriate to avoid hedging your energy price risk? A good risk management program will regularly force you to ask these types of questions. There are firms that may be well advised to avoid hedging but they are more the exception than the norm. Firms that can avoid hedging for extended periods tend to share a few traits.
- They tend to have diverse operations that reduce the impact of prices moving too fast in one direction. Major integrated oil companies, for example, have downstream units that benefit from lower oil prices (relative to products prices) and can wear some of the risk of an unhedged upstream portfolio.
- They tend to be cash rich which allows them to fund their operations during periods when commodity prices (low in the case of a producer, high in the case of a consumer) lead to lower cash flows.
- They tend to have low fixed costs and debt levels.
- The demand for their product(s) or service(s) is sticky and they have the ability to influence the price.
For most companies, analyzing the merits of hedging their energy price risk is at the very least, a good business decision. Few companies can say that they can afford to manage major prices swings without incurring some pain. Ultimately, you should hope that hedging your energy price risk will be a small cost of doing business; hope it will be like insurance you never need.