California proved hedging can be painful

John Wengler and Jay Lindgren, R. W. Beck Inc.

The “California Crisis” may have disappeared from the front pages, but organizations that purchased forward contracts at high-water prices in the spring of 2001 continue to feel the pain. Power and natural gas prices have dropped so low that these long-term contracts now appear horrifically over-priced.

Many of these “hedges” were entered to ensure price reliability-they reduced price risk by fixing that price. Ironically, these hedges are working exactly as planned-albeit at what are now considered obscene levels, proving yet again that no good deed will go unpunished.

This post-California experience proves hedging is rarely painless. In fact, the practice of hedging only allows organizations to pick their poison-price certainty or price risk in volatile markets-rather than eliminate the pain all together. The secret, therefore, lies in the organization’s hedging objectives.

Hedging and price strategy

Consider a utility facing the following paradox of procurement: The utility has an obligation to deliver electricity at a fixed price. Should it lock in a price today, which may not be a pleasant price, or wait, hoping for a potentially lower price?

If the organization truly wants to minimize risk, the proper hedging strategy would be to secure all the power necessary to serve load regardless of the price of that power. In other words, a pure risk-reduction strategy must be indifferent of market pricing. In this price-blind environment, hedges that wind up being “over priced” compared to actual market prices cannot be criticized for losing money because making money was never the objective.

If the organization does not want to hedge away all of its risk, a pricing strategy can help set boundaries that can trigger hedging activities. The concept is to set a range of prices in which the organization accepts market risk if prices:

  • exceed a certain ceiling price, the organization would attempt to lock in at that ceiling price as a hedge against further increases.

  • drop to a floor level, the organization would attempt to lock in but forego the benefit of prices dropping even further.

A balanced perspective on hedging

The worst time to set a pricing strategy or start hedging is when market prices are already outside the range of the desired floor-and-ceiling prices. One reason so many organizations are now stuck with “California Hedges”–hedges entered after prices have already spiked-is that these same organizations had not properly hedged before the crisis. The decision to lock in power during the crisis should not be criticized, but their lack (or inability) to hedge before the crisis is a valid point of complaint.

Two comments about those “California Hedges:”

  • First, those contracts would have been considered brilliant if markets did indeed spike during the summers of 2001 and 2002. Even so, those hedges would have been no more or less effective, since the whole point was to eliminate risk and not optimize price.

  • The second point concerns viability. For some organizations, there is a price high enough-call it the “Doomsday Price”-that will simply kill the organization. If prices reach this Doomsday level, that organization will not hedge at all, because it would be locking in pain too severe to tolerate. This organization may be better off taking a bet of even higher prices rather than facing death with certainty.

The secret to an effective hedging program, therefore, is to manage expectations by first setting organizational objectives.

The utility management must state its objectives: to eliminate risk, to maximize potential profit or something in between. This pro-active management will help avoid “Monday Morning Quarterbacking” by providing a better game plan at the get-go.

Wengler and Lindgren are energy risk management consultants with R. W. Beck Inc. and can be reached at jwengler@rwbeck.com or jlindgren@rwbeck.com or 303-299-5200.

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