As energy hedging advisors, we often see many market participants, make significant, if not catastrophic, errors related to their hedging strategies. While the overall hedging and risk management knowledge and expertise of most market participants continues to increase, many continue to make the same mistakes as their decisions are based on their opinion about the markets rather than data and sound analysis. In no specific order, these are the most common, avoidable hedging mistakes we have witnessed companies making in recent months.
8. "We quit hedging because we rarely or never made money from our hedge positions." Hedging is not and should not be considered a potential source of revenue. A proper energy price risk management program should provide your company with one or more of the following benefits:
- Reduction in cash flow volatility
- Cost or revenue certainty
- Ability to lock in a profit margin(s)
- Price protection from increasing or decreasing prices
7. "Hedge but don't leave money on the table." This is simple to avoid in theory but more difficult in practice. If you are willing and able to hedge 100% of your exposure by purchasing options you can succeed in theory but in practice you will have to leave at least a minimal amount of money on the table in the form of option premium.
6. "Our management team disagrees on where prices will be trading a month, quarter or year from now." Hedging decisions shouldn't be made based on your opinion on where prices will be trading tomorrow or several years down the road. If it were simple and easy to predict where energy prices will be trading at any point in the future everyone would simply close their existing businesses and trade from a smartphone on the beach.
5. "We're going to wait and see what prices do over the next few weeks." What will you do in a few weeks if prices do not move in your favor? Will you continue to "pray and wait" or will you "cry uncle" execute a trade?
4. "We'll hedge as soon as the market provides a good opportunity." What if the good opportunity you're hoping for doesn't arrive for a year or two? How will your cash flows, expenses and/or revenues impact your bottom line between now and then? Will you be able to survive? What will happen if your competitors are hedging while you are sitting on the sideline?
3. "We only hedge when we have a strong opinion about market prices." What if your strong opinion turns out to be completely wrong? Can your business afford your strong, but incorrect opinion?
2. "Since prices have been declining we're going to wait until they recover." What if prices continue to decline rapidly? Are you going to have the discipline to hedge at that point or will you continue to wait and see if prices recover at some point down the road? What if prices don't recover in the foreseeable future? The opposite argument is often made when prices are in a "higher" price range.
1. "We're going to wait until prices hit rock bottom." This seems to be the favorite flavor of the month among many energy consumers. Trying to call the top or bottom of any market, let alone the global energy markets, is close to impossible. It's something that even the most successful traders rarely do during their entire career. How will you react when prices do hit rock bottom and begin to trend higher? Will you be willing and able to bite the bullet and hedge your exposure?
In closing, if your company has meaningful exposure to energy prices, regardless of whether you're a consumer, producer or processor, the key to success (in low, high and moderate price environments) is to develop and implement a sound hedging policy, procedures and strategies which are based on data and analysis, not opinions.