Long-Term Price Hedging Helps Relieve Energy Volatility

An independent steel manufacturer's cost of natural gas has been $1.42 million below market prices because of its long-term hedging program -- an amount equal to 10% of its total energy spend for natural gas.

As hurricane season once again impacts oil and natural gas supplies in the Gulf region, we are reminded that volatility is intrinsic to energy markets. Volatility and risk -- whether from political unrest, economic changes, industrial accidents or a Category 3 hurricane -- can't be eliminated from the energy equation. But tools do exist that can mitigate the shock an end-user experiences from sudden price increases, enabling it to better manage costs and maintain cash flow and profitability.

One of the most effective of these management tools is long-term price hedging. By purchasing contracts for oil, gasoline, natural gas or electricity months or even years in advance, the effect of short-term price spikes lessens. Without hedging, manufacturers are subject to the same price swings that consumers feel at the gas pump or in their monthly heating and electrical bills. An effective hedging program can mitigate these unwelcome changes and allow for more predictable business planning.

Many types of hedging strategies exist, but the goal always remains the same -- to fix the price for a portion of a company's energy needs in advance, when volatility is less pronounced. To execute a long-term hedge strategy, a company first procures a baseline of energy volumes based on its current market pricing and usage requirements. This baseline, or baseload as it's known in the industry, creates the foundation for the company's long-term hedging decisions.

Next, a series of incremental futures contracts is purchased for specific future time points. An example might be 85% of the baseload at the next month; 45% at 12 months; 25% at 24 months; and 15% at 36 months. Every month, new futures contracts are added in a rolling program that continues until market factors dictate a change in strategy.

As an example of the benefits of long-term hedging, one of our firm's clients, a major independent steel manufacturer and processor, sought to hedge natural gas purchases for its nine production facilities in the U.S., Mexico and Canada. In 2004 the company began a 36-month hedging program; as part of the effort the company receives continual guidance on market trends, enabling it to understand potential movements in prices.

Only a year after initiating its program, the manufacturer was advised to modify its strategy as Hurricane Katrina approached. Advance purchases were increased and hedge percentages adjusted to reflect the anticipated market change. The shift enabled the company to minimize its exposure to a violent spike in natural gas prices.

Even more useful, however, has been the relative stability hedging brings to the steel producer's budgeting process. The company is hedging 80% of its anticipated gas supply needs for the coming year; assuming that its usage stays the same, it is only taking a risk on its anticipated spend for the remaining 20%, which will be purchased at market price. Through its risk management program, the company is able to determine realistic forecasts for its budget.

Over the past four years, this manufacturer's cost of natural gas has been $1.42 million below New York Mercantile Exchange market prices because of its long-term hedging program -- an amount equal to 10% of its total energy spend for natural gas. It's critical to note however, that hedging, while an effective risk management strategy, can also cause a user to pay higher-than-market prices. In the final analysis, hedging is nothing more than a way to reduce price uncertainty, turning an unknown future cost into a known cost.

Long-term energy hedging works when the customer focuses on managing risk in an extremely volatile energy market, rather than attempting to "beat the market." It should also be noted that hedging is only one of a number of ways for a company to manage energy risk. Comprehensive market intelligence is essential, and must consider the influence of physical, financial, regulatory and legislative factors. Strategic sourcing, alternative fuel analysis, invoice auditing, self-generation, and conservation practices are all effective tools, and are often practiced in combination with a hedging program.

Ultimately, a thorough analysis of a manufacturer's situation is the only way to determine the best energy management strategy for its particular needs. But when markets are buffeted by factors as unpredictable -- and as potentially violent -- as a Gulf coast hurricane, hedging can help maintain the stability so critical to wise corporate management.

Andrew (Drew) Fellon is chief executive officer of Fellon-McCord & Associates, an energy consulting and management company based in Louisville, Kentucky www.fellonmccord.com

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