Hedging as Energy-Management Strategy

Hedging as Energy-Management Strategy

Well-executed hedging strategies can help manage energy costs in the midst of volatile market conditions. Even with some commodities stabilizing, energy-management expert Tim Statts says now's the time for manufacturers to review their hedging practices.

The natural-gas supply in 2011 is expected to far exceed demand, which portends lower natural-gas prices and less uncertainty over natural-gas prices this year.

That's good news for operations executives and plant managers responsible for managing their facilities' energy costs. But Tim Statts, vice president of risk management for Summit Energy, a Louisville, Ky.-based consulting firm that provides energy-management and sustainability services, cautions that manufacturers shouldn't get too complacent about energy-management strategies such as hedging.

"Now is a great time to be looking at your hedging practices because particularly in gas we've seen an easing of volatility," Statts says. "And anytime we see those types of easing, we as manufacturers, as buyers of energy, tend to think they'll last forever. And they don't."

Tim Statts: "Now is a great time to be looking at your hedging practices, because particularly in gas we've seen an easing of volatility. And anytime we see those types of easing, we think theyll last forever. And they don't."
Certainly not all energy commodities have stabilized. Crude-oil prices have been on a roller coaster ride as of late. Around the December holidays, oil prices approached two-year highs. In January, after prices declined a bit, positive unemployment statistics released by the Department of Labor had some analysts predicting that oil prices could reach $100 a barrel.

"Natural-gas volatility has been somewhat diminished over the past six to 12 months, but the crude-oil volatility has been pretty excessive," Statts points out.

All the more reason to evaluate your hedging strategies, Statts says -- or to consider implementing a hedging strategy.

What is Hedging?

"Hedging, in its simplest form for a manufacturing plant, is taking purchase positions on a commodity," Statts explains. "For example, a manufacturing plant that consumes natural gas is going to be naturally short.' In other words, they will continually be pumping some amount of natural gas into their processes to help heat ovens, to run equipment and to do the various things that manufacturers need to do to run their plants.

"Because they're naturally short, they always have an exposure to the price movement [of the commodity]. By taking purchase positions, they are hedging pieces of that short position."

There are two basic forms of hedging: physical hedging and financial hedging. Each comes with its own set of pros and cons, depending on the type and size of the manufacturing operation.

In physical hedging, a manufacturing site that has its own unique natural-gas supplier locks in a price with that supplier. In financial hedging, a manufacturer with multiple sites aggregates the total volume of the natural gas needed for those sites and goes through a bank to lock in a price for that commodity.

One of the key advantages of physical hedging, Statts says, is that it does not subject manufacturers to the accounting standards associated with derivative instruments and hedging activities. Those accounting standards apply to financial hedging.

On the other hand, in an environment in which "credit-stress issues are a bigger part of the risk-management portfolio than anything today," the creditworthiness of some physical suppliers can be a concern.

"A big advantage of financial hedging is you're going to be putting your positions on with large banking institutions such as Goldman Sachs and Bank of America," Statts explains. "Their credit standing is much stronger than the credit standing of a niche regional physical supplier. It's not that the niche physical supplier is a bad credit exposure necessarily; it just means that their credit might not be as good."

Hedging isn't necessarily a cost-saving strategy, asserts Statts. It's more about "creating a mechanism to help manage costs better." That can benefit manufacturers in a number of ways, from helping them establish "some cost certainty when they go to Wall Street with their earnings estimates" to helping them "mitigate exposure to [profit] margin uncertainty" by hedging as product is sold.

"Manufacturing sites are looking at anything they can do to reduce costs, and if they can't reduce them -- which, in a commodity market, we can't control which way the market goes -- they're looking at anything they can do to manage their costs and create more predictability in their costs," Statts asserts. "There's a high value to that in the manufacturing world. And being readily available, those tools are being used more and more every day."

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