As energy trading and risk management advisors, we're often asked: What are the "big picture" keys to success as it relates to energy hedging and risk management. In no particular order, here is our current top eight list as well as our take on each:
- Many companies deny or ignore the fact that they are exposed to significant energy risk. Be it electricity, crude oil, diesel fuel, gasoline, natural gas, propane, etc. many businesses are exposed to energy risk, too many simply choose to ignore it.
- Managing energy risk means not only managing price risk but basis, credit and operational risk as well. Sure, price risk is the primary risk faced by most but ignoring basis, credit and operational risk can be just as fatal.
- One of the most common energy hedging mistakes made by producers, consumers and marketers alike is paralysis by analysis. Rather than developing a game plan to manage their energy risk, many companies fail to take action or implement their risk management plan because they can't see the forest from the trees.
- The most common energy hedging benchmark - did the hedges make money? - is also the most meaningless because it ignores the underlying risk being hedged. The purpose of hedging is to mitigate risk, not to generate revenue or income.
- If you are not willing to look after your own energy risk, you can't expect your accountants or lenders to look after it either. Are you relying on your bankers to suggest hedging strategies and/or your accountants to tell you whether your hedge "worked" as intended? If your answer to either question is yes, you should probably go back to the risk management policy "white board".
- While energy prices are often mean-reverting in the long term, that does not mean that cumulative gains and losses (or opportunity costs) on constantly changing risk exposures will ever equal zero. Consider a large diesel fuel end-user that didn't hedge their exposure to fuel prices over the past two years as they assumed that the price increases and decreases over the said time frame would offset each other in the long run. Sure, they "benefited" during the third and fourth quarters of '08, while fuel prices were declining, but during all other quarters of the past two years they were left exposed, unnecessarily, to rising and volatile fuel prices.
- The best way to manage energy risk is to develop a formal energy hedging policy, including pre-approved hedging strategies, and stick with it. One-off hedging decisions almost always lead to disaster. When the one-off decisions don't lead to a disaster, it's almost often due to a heavy dose of luck.
- Managing energy risk is best approached by consolidating the risk into a comprehensive portfolio. Regardless of whether you're an energy producer, consumer or marketer you should manage your energy risk (price, basis, credit, operational) via a portfolio approach. Sure, you want to be able to isolate each risk type in it's own "bucket" but you also need to be able to see the big picture.
As always, if you'd like to discuss these topics or anything else with us, please send us an email or give us a call.