All about hedging

It goes without saying that producers and consumers of energy face a lot of price uncertainty. For both corporate and sovereign energy producers and consumers, that price uncertainty can make it difficult to make rationale and strategic decisions about the future. Just as each point along the supply chain affects price formation, so too can price risk at each point on the supply chain be managed (see below). Hedging with derivatives is one tool available to help mitigate — although not eliminate — price risk.

Above all, hedging is risk management. The intention of hedging it to smooth paid or received commodity prices, not to structurally increase or decrease them. If prices trend up or down consistently for an extended period of time, the producer or consumer ultimately will still be exposed to that directional trend. But if prices move up and down frequently over a period of time, hedging will protect producers or consumers from that volatility. As such, disciplined hedging over a long period of time really should neither make nor lose money on a net basis, but should be expected to make or lose money in any given shorter-term period.

Hedging helps producers/consumers plan in the short- to medium-term by providing certainty, or a band of certainty, around what commodity price they will pay or receive. Derivatives hedging is not a marketing strategy or a procurement strategy; it complements a marketing or procurement strategy. And it works best when it is done in a highly disciplined and programmatic way. For example, producers/consumers should have hedging targets in mind for certain time periods and parts of the forward price curve, and should not try to predict future prices or “time” the market. Delaying a hedge program for a month or two within a quarter, for example, might make good sense, as would hedging slightly bigger or smaller than planned volumes opportunistically in response to price behavior. But waiting until the end of the year to execute an annual hedge program in the hopes of better pricing violates the concept of risk management.

Hedging mechanics

Hedging instruments or structures can be very simple or quite sophisticated, but in either case are executed using financial derivatives: futures, swaps and/or options.

Exchange-traded futures and over-the-counter swaps both lock in advance a specific price for a specified volumes of a commodity that will be physically delivered in a specified future time period. The mechanics of futures and swaps are different, but they accomplish the same thing. The advantage of using plain vanilla futures or swaps to hedge is that the producer/consumer knows its precise price outcome immediately. As the most vanilla instruments, futures and swaps also typically have the best liquidity (though liquidity varies with product and tenor). But precise price certainty is also the disadvantage of hedging with futures/swaps; by locking in a single price level, producers forgo any potential price upside, and consumers forgo potential price downside.

Options are more like a price insurance policy. Buyers of options pay a relatively small premium upfront at the time of the transaction to reserve the right to buy or sell a commodity at a certain price level during a specified future period of time. Call options give the owner the right but not the obligation to buy a specified volume at a specified strike price during a specified period of time. A put option gives the owner the right but not the obligation to sell a specified volume of crude at a specified strike price during a specified period of time. The advantage of options is that they allow producers to participate in price upside above their strike price, and allow consumers to participate in price downside. The worst case scenario of hedging with options is known upfront: the worst case scenario of hedging with options is that the option expires with no value and the owner “loses” the premium paid.

Hedging strategies can get more and more complicated from there, with structures such as collars, three-ways, knock-ins/knock-outs, extendables/cancelables, and various structured and/or leveraged products.

Hedging tenors

Tenor refers to the part of the forward curve that is being used to hedge. For example, one might hedge six months forward on the curve — i.e. manage the price risk for a commodity that will physically change hands six months from now — or three-plus years forward on the curve. Generally speaking, market liquidity is best in shorter-dated tenors, and starts to deteriorate further out on the forward curve. However, there is significant variation in curve liquidity from one commodity to another. Liquidity can also improve or deteriorate in the long-term and in the short-term for a variety of reasons. Very generally speaking, benchmark crude oils (WTI, Brent) have very good liquidity in the two year tenor, and adequate liquidity to five years. Henry Hub natural gas (and even some of the more liquid basis markets) has better liquidity in longer tenors. Refined oil products have good liquidity in year one, and adequate liquidity in year two.

Hedgers typically "layer in" to hedge programs, meaning that they hedge a high percentage of production/consumption in near-dated tenors (say, 6-12 months out) and gradually add smaller percentages in longer-dated tenors. For example, a producer might aim to hedge 60-80% of current year/year 1 production, 20-40% or year two production, and 5-20% of year 3 production. Determining how much to hedge in various tenors depends on the product being hedged, and also on market conditions such as the shape, or term structure of the curve (see more below).

Term structure in the context of hedging

The shape, or term structure of a commodity curve — whether the curve is upward sloping or downward sloping — is another factor for hedgers to consider. A basic overview of term structure is below.

When a curve is backwardated (downward sloping), the commodity is bought or sold in longer dated tenors for less than its price today. While a higher outright physical price is of course beneficial to producers, on a relative basis this “positive carry” associated with a backwardated curve is actually attractive to consumer hedgers, but not attractive to producer hedgers. If the curve maintains that general shape over time, it means that consumers will have bought at a relative discount; producers will have sold at a relative discount.

When a curve is in contango (upward sloping), the commodity is bought or sold in longer-dated tenors for more than its value today. Lower outright physical prices are beneficial to consumers but the negative carry associated with a curve in contango is attractive to producers. If the curve maintains that general shape over time, it means that consumers that hedged forward will have bought at a premium; producers will have sold at a premium.

Benchmarks, basis risk, and proxy hedging

Commodity markets trade benchmark products to represent an extensive range of grades, qualities and delivery locations. For example, while there are many grades of crude produced and sold in North America — with different qualities and in different locations — West Texas Intermediate (WTI) serves as a highly liquid benchmark against which the other grades can be priced. The difference between the benchmark price and the price of another grade is the differential, or may be referred to as the spread. In natural gas, the distinguishing characteristic between markets is the delivery location, not the quality of the gas. Different gas delivery locations are called basis markets or hubs. The difference between Henry Hub and another basis location is called the basis spread or differential. The difference between the price of crude and the price of a refined product is called the crack spread. (Read more about differentials and basis risk here).

Hedgers also sometimes “roll up” over time from more liquid proxies in longer tenors to less liquid specific risk in shorter tenors. For example, an airline’s specific price exposure is to jet fuel, but jet fuel is very illiquid in longer tenors. Ultra-low sulfur diesel (ULSD) is somewhat more liquid, and WTI/Brent are of course the most liquid of all. So an airline might consider hedging three years out with crude, rolling that hedge into ULSD around 18 months forward, and rolling again into a jet fuel hedge six months forward. There would be transactions costs associated with essentially hedging three times, but the airline would have to weigh those costs against the risk of leaving part of their price exposure – i.e. the difference between the change in the jet fuel price and the change in the crude price -- unhedged, or floating.

The business of hedging

Market makers facilitate hedging business. Unlike in equities trading, commodity market makers do not charge a commission for trades. They make money by charging a spread — i.e. by offering a slightly higher price to buyers and slightly lower price to sellers. How wide or narrow that spread is on average across market makers depends on liquidity. Markets with lots of would-be buyers and lots of sellers should have a narrow bid-offer spread. Markets with a small number of buyers and/or sellers should have a wider spread. Markets with many would-be buyers but few would-be sellers at a given time will skew toward a higher price, and vice versa.

The price and spread that an individual market maker offers will also reflect the other trading flows that they are seeing at the time and — for market makers that warehouse risk — the risk that the market maker already has on its books. For example, if a market maker has just taken the other side of a large producer hedge, it will be well-positioned, or “axed,” to provide more competitive pricing to consumer hedgers than another market maker might be. This is one reason why two market makers might quote different prices for the same trade at the same time. Other reasons might have to do with the credit exposure that the market maker already has to the hedging counter-party, or the business relationship that the market maker has to the hedger in other areas such as lending.

Bigger, more sophisticated energy producers/consumers may run their own risk management trading operations and trade via brokers, banks, or directly via the exchange. Smaller, or less sophisticated producers/consumers might not dedicate in-house resources to this purpose and rely more heavily on their lending banks for hedging advice and facilitation.