What is Hedging?

Many trading and risk experts would read this headline and think: Why would one start with such a basic question? On your notes page, write your hedging definition of hedging, even just one word to one sentence. Or, a paragraph, and let’s compare it with others, internally to start, to find common ground. Then, on another day, ask three peers to write their own. Do you think they will be materially different? I bet a month’s worth of free consulting it will differ materially.

The reason is, is that I expect most answers will have these key words: Reducing risk, managing risk, managing uncertainty, managing to budget certainty, etc.

Before articulating my hedging and/or risk management definition, I doubt anyone would argue that hedging has a combination of science, math, and a lot of human nature embedded into the definition and practice.

Now, you have completed your definition, right? We are ready to unpack my approach to this subject with this basic premise:

Risk is good! That is premise number one and this will evolve as a positive connotation.

Further, hedging is simply a strategic and tactical avenue to ensure we consider risk is positive through a few of these summary level pursuits:

• Maximizing Profit
• Maximizing Cash-Flow
• Maximizing Risk
• Maximizing Reward
• Maximizing Cost/Benefit
• Maximizing Budgets

 

Is it curious to you that I did not use the word minimize? Reduce? Or, eliminate?

Did you also notice I did not say, for clarity, speculate, bet, or gamble? Minimizing to gambling, or speculating to betting are neither prudent strategies. The reason I make this so poignant is that I want to align to every individual, company and entity world-wide to their company objectives.

Why have I chosen to articulate hedging as maximize?

To align to our society as well.

Our society is capitalist based.

It is free-market based.

Which means, we are risk takers, right?

Therefore, risk is good. Not a negative connotation, a positive one.

The goal then becomes a strategy to maximize, or to optimize the outcomes we seek.

What does optimize mean?

It is straightforward, too – optimize is maximizing outcomes. Therefore, we will use these interchangeably in this book.

We are working to maximize the results for the company. That starts with objectives, followed by strategies, which require goals and tactics to meet these all the way to earnings, budgets and cash flow.

No doubt no two companies will have the exact same mix of optimization required to meet their free-market based capitalist objectives. That is why I cannot, nor can anyone, walk in the door and say, “Hire me, I have all the answers.” Not yet, that is.

Therefore, I cannot tell you what the optimal level of risk is best for you, or for anyone. And, for anyone to ever suggest such a thing in writing, before understanding the objectives of any entity is selling “vapor.”

We will help you, though, through the fog by guiding you through the light and the dark to establish the most optimal solutions, maximizing your goals, delivering you benefits, not big bills.

Therefore, optimal objectives will have a combination of the following, and more:

>Maximize Budgets

>Maximize Cash-Flow

>Maximize Profits

>Maximize Operational Objectives

>And, other Maximizing connotations

Any definition beyond this would suggest I, or anyone, has a magical formula for what hedging is and how to apply it. Do we have lots of opinion, ideas and approaches that we have done successfully, or have seen successfully implemented?

Yes, absolutely, but how you get to success is more important than how everybody else has done it. No two people are alike, certainly no two companies are alike. Are we still in alignment on these concepts?

Why do I now not jump right into proposing a “system” or “mathematical tool” or “software package” to solve all your hedging and trading solutions?

First, we should understand the human nature, the culture, that is involved more than in the hedging or trading strategies. Until we have the people and processes aligned, the systems won’t be nearly as successful.

Further Alignment

Also, notice in my definition of risk, I do not suggest that maximizing risk means you either make or lose money by hedging? This is very fundamental as well because everyone should generally agree upon this definition before engaging into hedging strategies. Trading strategies, yes, making money and making money consistently, year after is very important.

Human nature, though, many times equates hedging to either a perception of losing or making money. Losing money by hedging probably fits into the quote I use often, “Belief and seeing are both often wrong”, said by Robert McNamara, Secretary of Defense in the 1960’s, as well as CEO Ford before his service to this country.

Perceptions are free to be created ex post. That is, when a poorly designed, low disciplined, low understanding process is in place, it is a free option leaders use often to be spun after the fact. That happens way too often.

We have all seen the headlines saying the “Big Hedging Losses” costing millions, billions, costing one’s jobs……. Most of these headlines are nothing more, and generally not reliable, to suggest someone is right or wrong.

Nobody cares if they are right or wrong anyway. Perception is most of the equation we seek to clearly reduce or eliminate in developing a great hedging or trading strategy.

However, human nature often drives the headlines externally, and drives them internally within any entity. These are more distractions than reality, and they have impeded individuals and companies from focusing on “maximizing” their objectives moving forward.

Therefore, until one can truly understand what are the objectives and the human nature involved in any firm, regardless in the same market on the same street, there is no magical hedging program that will evolve from this book save the most important practical approaches to any hedging program that you must have to be successful in business. When you do, all else will fall into place.

The line I do draw in the sand is that I will suggest that having no hedging or risk management program in place, and discipline, that removes as much human nature as possible, nearly ensures that one day, a hedging program will be borne out of reaction to unforeseen events, market volatility to market structural changes to politics, internal and external, economic, or mother nature driven. And, you will be a headline, not a hero.

Yes, I am saying you must have a hedging program. This is the only bolded word in this book. Understanding that this is important will reduce the blood pressure increase many are now feeling.

For additional clarity, I am not suggesting that having a hedging program means you are trading actively, daily, or ever trading, or selling or buying anything.

What I am suggesting is that since we have a risk based society, you must have a program in place that enables you, regardless of size, to manage risk, to maximize risk, and to do it better than the rest of the marketplace to maximize profits and cash flow.

In any situation, there is human nature, there is a positive correlation with decision- making and reacting to events surrounding us, personally or professionally.  Therefore, we must too cover what hedging is not to ensure we gain internal clarity.

 

What Hedging is Not!

Before diving into where a hedging program starts, it is important for this author to state that regardless of the human nature, math or science, hedging is not about making money or losing money. I can’t say that enough.

Can a hedging program produce losses? Yes, when done poorly where someone does not hedge, or hedges 110% of their revenue or margins, et al, that produce losses.

No decision at all. Or, no hedging program in place is also a decision.

Losing money is not because one had to pay, rather than receive, for contractual hedging obligations either. Losing money is defined as the opportunity cost of not engaging into hedging programs, or, as I state, not understanding and not maximizing the risks that you naturally undertake in your business.

And, utilizing an improper balance of tools, not enough tools and tactics, and not understanding many of the basic pricing and valuation techniques, hedging encompasses and produces less than maximum, or optimal results. This is a big issue for many hedging in some markets more than in others.

Today, some industries have levers, cards to play, but those cards or rate-case increases, for example, are increasingly going challenged in the face of many structural changes to how we harvest and use energy.

It is truly a game-changing period we live in, and it provides great opportunity for those who care as well about society, to make more impact, and to leave their footprint, not carbon, but a footprint people will want to continue following years after you leave, after you retire.

To that end, when hedging becomes political, or becomes the issue for why a company performance is not to expectations, real or perceived, it is usually due to the fact a disciplined, communicated and approved hedging program is not completely understood from the day-to-day activity level to the senior management and up to the board level. Or, that a policy mistake, or intentional decision to add or to unwind hedges is made for accounting, not for economic reasons.  I have seen the latter as well many times.

I must make this assertion clearly as I have seen perfectly working, disciplined hedging strategies added or removed under the disguise of hedging, or for the very unfortunate reason that the hedge, which was deep in the money, was unwound and the resulting cash inflows were then re-classified in the financial statements from the balance sheet to the income statement to meet, or inflate current earnings.

That is without saying, not hedging or risk management, but speculation and/or manipulation, which this book does not propose without rational reasons, such as changing market conditions – i.e. a material change in the risk/reward profile that is driven by market forces, not internally suggested political forces. Exit strategies will be explained, too, to cover all bases. I will share a few of these stories in the stories chapter.

 

Health-Check?

Even if you have approved hedging programs, it may be a good idea to ask for a complete “health check” of your hedging program to ensure alignment not just within the energy group, but up to senior management and up to the board level. You must be sure you are clear, in demonstration and in writing that you are maximizing the strategic goals and objectives with hedging programs. Half-baked, incomplete alignment will also lead to issues, one day.

Therefore, each year, at a minimum, reinventing the hedging and risk management program is probably a good idea. Why?

In what company has management not changed in the last year?

In what company has a new board member arrived?

In what company has the price, margin, customer numbers, customer mix, competition……not changed?

And, in what company are you 100% aware of the pending changes – i.e. selling of an asset, a division, or the entire company? Or, the opposite, you are not aware that your company is about to buy a very large company that will completely change your company’s risk/reward profile?

Maybe your company executives believe they are not taking enough risk, and that hedging may not make the risk/reward profile the company executives are trying to achieve attractive going forward?

With change increasing at an ascending rate, and doing more than a review, a complete “health check” of your program is prudent, and shows you are thinking like an executive, which is a role many desire to achieve themselves.

If you are not convinced that hedging programs can go awry, just use a search engine and type in the phrase “hedging losses,” and see how many articles appear. You will be very surprised to learn that hedging losses, with all the right intent, have caused many, many issues with many companies worldwide.

You may already have direction to simply just hedge transactions based on time, volume and/or customer purchases and/or sales, or production or load forecasting models. Even if you take it for granted, I would also propose you simply ask: Does our hedging produce the desired result we are trying to achieve annually?

For those who have loosely defined, not well communicated, or well understood hedging programs which may be a perception or accepted reality, validation is key for your program.

When I speak with clients I too get the feedback from executives that they are completely 100% hedged and have no issues, needs, and are rather comfortable in their situation because their program is the same as it has been for decades. “We are good” is my favorite, often stated, almost with arrogance response.  And, the confusion of this statement alone suggests risk is abound.