While many companies know that they need to hedge their exposure to volatile energy prices, many struggle to understand the various hedging instruments, such as futures, swaps, options and collars, not to mention how they actually function within a hedging program and which are best suited for particular market environments. As an example, in a bearish environment, such as the current natural gas market, purchasing put options is often a superior hedging strategy for a natural gas producer, as opposed to a fixed price instrument like a swap, as a swap eliminates the producer's ability to participate in the “upside,” should natural gas prices increase during the life of the hedge.  On the opposite side of the spectrum, fixed price instruments, such as a swap, can be a sound hedging strategy for a natural gas end-user in a bearish market environment.  

How an energy hedging instrument settles against the underlying commodity or index makes is very important as well.  To determine what type of instrument best matches your exposure you need to determine whether your exposure is “priced” at the beginning of the month, against an average over the course of a month, etc.  Once this has been determined, then you can determine whether your hedging instrument(s) of choice should be of an American, European or Asian variety.  For those who aren't familiar with these terms as they related to hedging, they aren't referencing people or cultures, these are simply the terms used to specify the various settlement types of derivatives.  If the price you pay or receive is based on a “first of the month” price, you don’t want your hedge to be based on a monthly average price, or vice versa, for a number of reasons, not the least of which is a potential cash flow issue.  

Also, details such as how close to-the-money an option you should buy or sell poses additional questions that need to be addressed as well.  As an example, an at-the-money option has a greater probability of settling in the money than an inexpensive, out-of-the-money option, simply because prices have to increase or decrease, depending on whether it is a call or put, respectively, more for an out of the money option to be in the money than an at the money option.  If the "money" jargon is confusing, give us a call, we're here to help.

It’s also worth noting that when one is attempting to capture an “attractive” price, whether it’s a “low” price for an end-user or a “high” price for a producer, options are often ideal because they ensure that you have captured the attractive price, while also allowing you to benefit should prices become more favorable.  

Last but not least, even when it’s determined that “fixing” your price is an appropriate hedging strategy, initiating the “fixed” price hedge via an option strategy such as a costless collar (yes, while comprised of options, costless collars are generally used as more of a fixed price strategy as they provide little optionality at inception) can provide flexibility to improve the “fixed” price if the market turns in your favor.   After all, if the upfront, out-of-pocket costs are limited, do you really want to put yourself in a position where you are forced to buy $5.00 natural gas in a $3.50 market or, sell $75 crude oil in a $100 market?