Although some people think that hedging is an advanced and indistinguishable concept, the implementation of hedging is actually very basic. Risk managers can use futures contracts, over-the-counter trades, call options and put options and their combinations to lock in prices for a specific period of time. This allows the company to know exactly what they will pay for their energy during that time and plan the price accordingly. The real challenge of hedging is to build a strategy that meets corporate risk appetite and hedging goals.
Hedging to reduce risk
Hedging is especially important for companies that produce or consume large amounts of energy, such as natural gas, crude oil, and so on. However, many companies view hedging as a profit strategy, and this is not the case. The purpose of hedging is not to make money [and not to lose money], but to reduce risk. This in itself is another term that needs to be defined. In some cases, the company's risk will depend on the price of the energy they buy or sell. For others, risk can be defined as the opportunity cost of trading at a lower or higher price so that they can use the saved funds to advance other projects or technologies.
Most importantly, no two companies have the same risks. Therefore, anyone wishing to implement a hedging plan must find a qualified hedging strategy that meets their unique goals and risk preferences. The first step in doing this is to identify the goals of the risk and hedging plan, then develop a strategy to use the right hedging tools to meet their needs at the right time.
Here are some tools to help manage your hedging plan:
Futures/forward contracts
A futures contract is a basic contract that purchases a standardized quantity of predefined assets at a specific price on a specific date. Future contracts are guaranteed by the clearing house, which limits the risk of opposition parties defaulting. Forward contracts are standard contracts between the parties and do not have the same flexible terms and conditions as futures contracts. In addition, the opposition party has the opportunity to violate its commitments.
Option
Options are a very flexible hedging tool. An organization or investor can purchase a phone' option, the right to purchase an asset at a specific price, or the right to "place". Options are sold at a specific price on a future date. Unlike futures, if the market price is more profitable than the option price, the option owner does not need to complete the transaction.
Natural gas instance
Natural gas prices were traded in the horizontal range of $2.50 to $3.00 per MMBtu for the first eight months of 2015. Then, in September 2015, prices fell from a low level and hit a 16-year low of $1.611 in March 2016. Let's say that during this time a utility company wanted to build a new gas-fired power plant, but in order to fund such a project, they demanded that gasoline prices stay below $2.50 next year.
In this extreme case, the company does not want to miss the opportunity to build new facilities, but does not want to take a higher price risk. Therefore, their goal is to use futures or call options to lock in prices when prices fall below $2.50. Using futures limits the cost of hedging, but it also has more downside risks than using options. Options limit the risk of option premium costs, but the price must be well below $2.50, so the "all" cost of the strategy, the option execution price plus premium, is true. No more than $2.50.
Either way, in this case, the utility company knows what their goals are and can formulate a strategy to calculate the hedging time when the price falls below $2.50. Once they can lock in the price of natural gas, they will know that it is safe to propel the new power plant. If the price does not fall so low, they will know that they can't continue to advance the project.
in conclusion
Organizations that want to protect them from uncontrolled market volatility can at least provide better service by studying the services that the clear hedge program provides for the business. Market participants should be able to smooth the ups and downs of prices and develop strategies that meet their unique goals and risk preferences. A clear hedging plan is an important part of reducing energy price risk, and the right strategies and tools can help achieve the company's risk management and hedging goals.
Orignal From: The significance of hedging energy commodities
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