Hedging Tactics
A well-developed hedging program requires tactics. Many organizations that do hedge, while at the same time complaining that management doesn’t see the value they are adding, could rather spend that time focusing on the fact the world is full of color, not just plain vanilla.
The world is changing rapidly, and many companies are getting behind on many fronts.
Simple vanilla hedging tactics are just enough to get by, and generally are less optimal, and sometimes actually costly. Therefore, I wouldn’t wave a flag or say, “Look at what I am doing!” if I had a couple of fixed priced hedges on the books. That is old-school, and it is time for new school, 21st century techniques.
Unlike most books on this subject, as you have gathered, I will not be laying out a textbook definition of trading instruments with colloquial deterministic payoff profile charts to fill pages. If I can’t develop a picture of risk, with lots of color, I can’t discern if it is a sunny or cloudy day, much less hot or cold.
Therefore, painting a picture is worth more than words. As I see the picture, I may not digest the full ramification, as a CEO, on day one, but as time goes by, I digest it, you provide even more insight, others provide insight and I will be able to walk and talk all the models, software, and math alongside of you.
However, it is not important for me to understand all the details. I am a senior leader dealing with lots of human nature – dealing with human nature 90% of the time. That is why I pay you to paint a picture that is truly worth 1,000 words, and not just words, but tells a story I can then further articulate to shareholders and board members alike.
If you take any astute leader, which there are many joining the higher ranks daily, and you bring them a black and white picture that says, “I have three hedges averaging $3.50/MMBTU for a total of 40% of my portfolio,” and it also says, “I will collect $57 million in cash this year, with no other scenarios,” then I will find someone who can paint a multiple color scenario.
As we get deeper into this process, I do want to stop to provide additional clarity about two terms: physical optimization and hedging. Each is mutually exclusive to start.
Physical optimization, which is a word that is thrown around a lot these days, is by my definition a maximization of your natural position – assets, existing contracts, through to the customers you do business. I want to see a picture of my natural position first.
Hedges are levers that I will add subsequently, in aggregate, and hopefully in the same tool, and review independently as well.
Why?
I want to have transparency before engaging into material hedging programs now, or into the future. I will add for the power markets that I want the IRP (Integrated Resource Planning), or in a refinery to see a picture of my feedstock inputs to also be a separate iteration as I want to have a summary level of my natural position.
For clarity, I also do not consider physical optimization and hedging as the same technique to optimize cash, profits and to manage risk. Hedging is in addition to physical optimization, and may be either complimentary or supplementary.
As a CEO, I may not be able to disclose to your trading/hedging department that I am considering buying or selling assets. Therefore, if I ask you to run three more scenarios with material change to our asset position, it may be for curiosity, that I am naïve, or that I want to see what happens to our portfolio in the event I make decisions to enter or exit a company and/or enter/exit a market.
No doubt there are constant portfolio scenarios developing in every market. Markets, life, are changing at an increasing rate and you must prepare and simultaneously manage to those scenarios.
Going forward in this chapter, we will focus solely in discussing the hedging tactics for a static set of assets and contracts, along with the customer base, that I want to provide hedging tactics for to maximize cash-flow and/or budget certainty.
Physical and Financial
First, let’s discuss at a high level that we have two tactical paths – physical and/or financial hedging. Physical hedging is often used by simply buying fixed priced physical feedstocks in the forward markets. This is certainly, on the surface, the easiest approach, and the easiest to communicate up to the executive and board level.
However, it is more convenient than optimal.
There are untold examples of where holding fixed physical hedges also turns out poorly due to concentration risk alone. Power plants go out of commission, much less add legal, political, economic, social issues, and relying on one solo physical hedge approach is missing opportunity and leaving dollars on the table.
Trading companies, large and small, go bankrupt. Many companies have had to reset both supply and hedges due to this competitive, business environment. Some companies resetting hedges have come through with small hits to profitability, while others have had major hits in the last few years.
I am not spending time in this book any further about credit risk – it is another topic that does have to be measured and understood in the short term to the long term.
Modeling that risk as well in most physical optimization and hedging tools, especially for those who are trying to go from deterministic to painting a picture of risk through simulation, are not going to first focus on building this risk into the models, if that capability does not already come out of the box.
Therefore, when hedging, you are buying from multiple players, not just at the best price, or because the RFP says it is the cheapest. Throwing out a force-majeure, not delivering…, and these do happen at times. Disperse your portfolio hedging tactics to multiple players.
Physical Hedging
If I said anymore about physical beyond buying physical hedges for firm supply to your plant, I would be talking down to you. However, if your tools are not able to measure whether the physical purchases optimize your risk/reward profile because you buy calendar physical strips by thumbing it, this is just firming up some supply, not optimizing.
You already know there are shoulder months, cost-of-carry factors, supply/demand, pipeline issues at certain times over others. All types of these factors must be considered in creating optimal physical hedges.
Therefore, beyond this there is no one magical strategy that will fit one over the other. The point is, the more you think through and can apply these factors to your models, and formalize vs. thumbing it, the more you will maximize your hedging processes.
The better the communication, the more developed talking points, and you can make real inroads with senior management to the board level. A major physical opportunity, though, that is completely underutilized by most everyone are physical options.
Physical Options
For clarity, physical hedging does include options. Physical options are becoming more popular, and just because a great big company brings them to your doorstep does not mean that they know more about risk/reward than you do.
Big does not mean better – if you have been in trading a long time, you know what I mean. Big equals slow in many cases, and it also means they are as human as we are. Said another way, they may misprice these and give them away.
I know, I am a consultant and I see who uses deterministic pricing to simulation techniques; therefore, I can see who underprices options.
Therefore, calls, puts, crack options, swing options, heat-rate options, etc. should all be understood and included in maximizing your portfolio.
Also, considering the payment terms of physical vs. financial instruments can materially impact tighter cash flow budgets, especially in higher interest rate environments.
Storytime. I witnessed a company purchase a physical option with a deterministic tool. First, I should disclaim that I was at this client under my own direction. I was subcontracting, and even if I was the main contractor, it was not our scope to question their trading tactics or pricing.
Projects have enough challenges, and it is not up to me to think I know everything.
I do everything possible, unlike most consultants, since I have traded, run a risk desk and back-office too, to read as much of your public information as possible before arriving so that I can hit the ground running.
I rarely disclose that as it doesn’t impress anyone, but I do suggest it is a key factor in making positive suggestions to the client for them to consider and to make the decision for themselves.
Therefore, just because I was sitting on your trading floor doing what you hired me to do, should I then engage into something that is none of my business, but I can’t help overhear about these options you are about to buy, or sell.
Recall that FASB 133 story was about a trading book structure of proprietary trading vs. hedge book accounting – splitting the one book into two solved everyone’s front, mid and back issues. Therefore, when I am independent I can offer stellar solutions.
On that physical option story, if you are going to spend seven figures on an option that is a short duration in the nearby months, or out 5 years forward, please do yourself a favor and buy a tool that can provide a simulation result, an optimal, maximizing cash and risk/reward payout profile.
The moral of the story is not whether I know any more than the rest, it is the fact I see a lot of companies do a lot of different things with and without the proper tools. Since I have the local experience in trading, I do see things others off the street do not. What I am trying to convey is that having all tactical options, pun intended, at your fingertips is critical to success and they will pay for themselves.
Financial Hedging
In concert with physical hedging, it’s obvious there are more choices, and these choices provide simple to complex possibilities. I also lump futures trading into this category as most futures never see delivery.
The key to utilizing these is understanding the physical operational flexibility financial and/or physical provide – i.e. playing the spot vs. forward curves, storage vs. forward curves, and if you have any size to your positions, there may be months you do not hedge with physical, and roll into the spot via a material amount of your physical needs in the front months and utilize your storage to forward, or spot month to discern which economics optimize your cash flow.
If you are in either commodity or energy markets, you can’t miss the incredible amount of inventory in storage compared to not just the last five years or decades, but in nearly a century.
And, natural gas is about 1 Trillion MMBTU’s above any historical period on record, and oil inventory is the highest in nearly 100 years, so why not let the forward curve roll down to your spot needs more than before and optimize spot vs. forward periods.