Energy hedging strategies and trends in 2016
Taking a managed-risk approach to energy sector hedging
You can’t predict market volatility. But you can prepare. Learn how a managed-risk approach to energy sector hedging can help organizations proactively plan for the next market move.
- Adequately prepared?
- Market view vs. managed-risk perspective
- Managed-risk approach?
- Steps to a proactive hedge strategy
Are you adequately prepared?
As seen in energy trends in 2016, market volatility has thrust the topic of energy risk hedging—and what constitutes an effective energy hedging strategy—into the spotlight. For energy-intensive companies, now is a good time to consider:
- Does your organization have a clearly defined hedge strategy? If so, did it produce the desired results during periods of price volatility?
- Is your organization's energy hedging strategy tightly aligned to the company’s overall financial objectives and risk management program?
- Does your organization conduct scenario analyses and stress tests to determine quantitatively how potential outcomes of different hedge strategies compare to objectives?
- Does your organization have appropriate governance and risk oversight processes in place?
If you answered “no” to some of these questions, your organization may not be adequately prepared to navigate the next market move.
Market view vs. managed-risk perspective
Companies engaged in commodity transactions have deep and well-developed insights into current market conditions, past cycles, and future trends in pricing and volatility. But the problem with relying solely on a “market view” is that it leads people to make assumptions about the future based on what they’ve experienced before. This, in turn, can result in emotional decision making. In extreme cases, it can turn hedgers, who transact to manage risk, into speculators, who transact to make a profit.
In developing an energy hedging strategy, companies need to protect the organization against unfavorable market movements, whether up or down, and manage to a well-defined set of risk metrics. A managed-risk perspective, which is typically part of a broader risk-management program, measures and monitors the market risk of the portfolio against multiple criteria, such as revenues/costs, liquidity, hedge losses, credit, and collateral, to name a few. It also defines mitigating activities consistent with the stated objectives and risk criteria.
For one example, see our full report, which summarizes reactions to the spike, and then plunge, in natural gas prices in 2008.
What is a managed-risk approach?
A managed-risk approach is methodical and quantitative as opposed to being reactive and qualitative—and that’s where its effectiveness lies. Taking a managed-risk approach to developing an energy hedging strategy generally means:
- Establishing quantitative metrics to measure a company’s exposure to energy risk
- Using scenario analyses and stress testing to evaluate the hedge strategies available for managing that risk
- Developing or refining the hedge program by selecting the strategies that most closely align with the company’s financial and strategic objectives
- Executing the tactics as prescribed in the hedge strategy whenever metrics exceed pre-defined thresholds
Like a rudder, a managed-risk approach steadies the boat in choppy seas. With it, a company can make incremental hedging decisions based on the risk impact energy prices have on its objectives, as opposed to making bigger bets based on where someone thinks that market is heading.
Five steps to a proactive hedge strategy
An energy hedging strategy based on a managed-risk approach provides discipline and helps steer the organization away from trying to guess whether a commodity will bottom out, or conversely peak, at an arbitrary price point. There are five basic steps to developing a proactive, structured hedge strategy based on a managed-risk approach:
1. Establish a proactive risk-management culture
2. Undertake a qualified and quantitative risk assessment
3. Define hedging objectives to reflect corporate goals
4. Develop or refine the hedge strategy through stress testing
5. Establish governance processes and a risk-oversight structure
Preparation and deliberation
The energy industry—including the oil and gas and power and utility sectors—is one of the more mature industries where hedging activities are concerned. Nonetheless, for many organizations, reactions to short-term events are often inconsistent and a long-term strategic view is frequently missing. As a result, many companies do not manage commodity price volatility as well as they could.
Leading companies proactively plan for the next market move by taking a managed-risk approach to hedging, which can lead to more stable cash flows, a lower cost of capital, and smoother stakeholder relations. And in extreme market conditions, it can avoid the painful question: “Why weren’t you better prepared?”
For more insight into managed risk and energy trends, download the full report and learn about our managed-risk services for energy-intensive industries.