Energy is a significant cost for many companies. What’s more, very few commodities are as volatile. Energy commodities such as WTI crude oil, Brent crude oil, and natural gas are essentially comprised of speculators and hedgers. It is easy to make out what speculators are all about – they are taking on risk in the commodities markets to earn profits. Hedgers are somewhat of a different class. A hedger is essentially an entity that is engaged with a business related to a specific commodity. They are typically a manufacturer of a commodity or an organization that requires to buy large quantities of a commodity in the future. Hedgers are trying to reduce their risk by buying when commodity futures prices are low or selling when they are high.
Element of Correlation in Hedging
One of the most imperative elements of futures markets with regards to hedging is correlation. Successful hedges using futures contracts rely upon correlation, which deals with the pricing relationship between the spot price (or cash market price) of the commodity and the futures price. For instance, if the spot price of crude oil at some delivery point in the Eastern U.S. rose by $1.00 and the WTI futures contract also rose by $1.00, then there is perfect correlation and a hedge using the WTI futures contract for that spot market will work well. However, if the spot price rose by $1.00 and WTI futures fell by $0.25, then the correlation between the spot and futures price will not work for hedging purposes.
There are many ways to examine correlation, but the most common is coefficient of determination, denoted R2 or r2 and pronounced “R squared”. Generally one would like to see R2 of 0.80 or greater to prove the correlation is good enough for hedging purposes.
The primary objective behind a hedge is that the company signs a contract to purchase some part of a commodity at a set price. That pays off if costs rise, however it could be a money losing deal if they fall below the contracted level. Again, if the spot price rises but futures prices fall or do not rise in a similar manner, then hedge will not work.
Limiting Risks through Hedging
Hedging future relies on clear goals of what your hedging program will achieve. It also requires a clear hedging strategy. Here, the company can use a professional risk management company to assist, by providing an intelligent energy hedging strategy. The risk management company can help set up a strategy that will adhere to a company’s risk appetite and hedging goals. Such a strategy would tell the company when, how much, and what instruments to use when hedging. It will also give the company a structured and disciplined approach to hedging so that they can avoid making emotional decisions.
The Kase HedgeModel is an effective energy hedging and risk management product several companies have relied on since 1992 to, limit risk of future energy commodities price fluctuations. The product is based on statistics and market cycles and through charts helps identify when to hedge, how long a maturity to hedge, how to scale in and when to revise hedges.
Hedging is about managing risk and controlling volatility to the best degree possible. Hedgers protect their physical postion by purchasing futures contracts and derivatives such as options. Although the concept of hedging is simple, the execution much be well thought out and planned so that a company can achieve its hedging goals. This is why a hedge strategy is so important and why your company should seek help from a professional risk management company such as Kase and Company, Inc.