Hedging Commodities Is Not Gambling When Done Right
Hedging commodities seems to be a recent interest among many companies I have talked with. There are significant discrepancies of what a hedge really is/should be. Hedging a product can be better worded as insuring an outcome within a certain degree. Those who tout profits and riches are not talking about hedging, but gambling/trading. Gambling/trading does have its own merit when done right, but for this blog I would like to focus on hedging.
Hedging should not be focused on the concept of making money. It should be focused much like insurance. One does not buy insurance to obtain wealth, but to protect against wealth destruction. A proper hedge should protect oneself, commensurate with the level of cost for the hedge. An analogy would be buying a low deductible versus a high deductible insurance. The decision to purchase is the function of perceived risk and financial stability. Another misstatement by many is the fact there could be “free” hedges. There are no free hedges as there are no free cakes.
When to hedge? Hedging makes sense when the product to hedge is not a core part or does not represent a large portion of your business profits. If it does represent a large portion of your business, it should not be represented as only as a hedge, since the product should represent a large core competence of your business. Your team should have a good understanding of the trend and the fundamental nature of the product and be able to effectively trade the product. In the case it represents a smaller portion of your total cost of business, designing an effective hedging program would be a worthy cause.
A hedging program should be tailored and incentivized to reduce volatility and offer a stable cost for projections of earnings. It should not be seen as a profit center. Hedging programs which get caught up in profits eventually becomes a trading program. The hedging program may produce positive results, but these profits should be saved for the rainy days when the hedging program produces negative results. The best hedge programs are systematic.
I have many years in the trading environment along with the corporate planning environment. My group at AEP was instrumental in designing the first approved hedging program by the public utility commission for our supply chains consumption of on-road diesel and gasoline. At All Energy Consulting we understand the energy markets and can effectively navigate you in deciding and designing a hedging program for the various energy commodities. Please contact us to help you evaluate and/or decide on a hedging program.
Your Energy Consultant,
614-356-0484
Hedging article – http://allenergyconsulting.com/blog/2012/06/22/hedging-pitfalls/