Are You Hedging or Speculating When Managing Your Energy Price Risk?

While most companies approach energy price risk management with the best of intentions, human nature often leads far too many down the wrong path, the path of becoming an emotional, hopeful speculator. While speculation isn't a bad thing in and of itself, after all hedgers need speculators to provide them with liquidity, speculation masked as hedging often leads to incredibly poor and undesirable results.

Consider the case of the following two, fictitious North American airlines, Purple Airways and Pink Airlines. Purple Airways consumes, on average, one hundred million gallons of jet fuel per year. Their hedging program is managed by their CFO who "hedges" the company's jet fuel price risk by purchasing Brent crude oil futures, when he believes that Brent crude oil prices, one of the two global benchmarks for crude oil prices, are "cheap" relative to where Brent crude oil prices have traded historically. The tenors and volumes he decides to hedge are also based on his opinion of the crude oil markets such that as he becomes more confident about his market perspective, he increases the volume and duration of his “hedging” transactions.

Speculating vs. Hedging

On the other hand, consider the case of Pink Airlines, who also consumes, on average, 100 million gallons of jet fuel per year. Pink's hedging program is managed by a fuel hedging committee which consists of their CEO, CFO, treasurer and an independent fuel hedging consultant. The goal of Pink's fuel hedging program is to ensure that the program mitigates the impact that fuel prices have on the company's cash flows. To ensure that Pink achieves this goal on a regular basis, the fuel hedging committee has - working with their hedge advisors - developed a fuel hedging policy, as well as an accompanying procedural guide, which addresses all of the details that they are required to know in order for the fuel hedging program to be deemed a sustainable, successful program.

In addition, Pink's fuel hedging committee, as the result of extensive analysis, has determined that they will be able to meet their goals, regardless of whether fuel prices increase or decrease, by hedging 75% of their projected fuel requirements, on a rolling twelve-month basis, via a combination of Gulf Coast jet fuel swaps (25%) and Gulf Coast jet fuel average price call options (50%). Pink made the decision to hedge with Gulf Coast swaps and call options, at the previously mentioned percentages, as their analysis showed that this strategy will provide them with a hedge portfolio that best reflects their actual fuel price risk as well as their risk tolerance while ensuring that they won't face significant cash flow issues if fuel prices decline. As such, Pink's fuel hedging committee has moved forward accordingly, as dictated by their hedging policy and procedural guide. This includes holding efficient, bi-weekly meetings, during which time they review up-to-date reports of their existing hedge positions, fuel consumption forecasts, current jet fuel swap and option prices, etc. Before the conclusion of the meeting, they determine a course of action for the following two weeks. And two weeks later they repeat the process.  

Clearly, Pink's approach provides a sound "system" which will ensure that their fuel hedging program has a very strong probability of producing the desired results.  Purple's approach is, arguably, little more than a series of speculative bets on Brent crude oil prices, based on their CFO's option about the market at any given time. Furthermore, given that Purple's approach lacks any sound analysis, Purple will never be able to say with any confidence whether their hedging program can, has or will provide desirable results.