Hedge Your Bets
Manage your exposure to volatile and rising prices for natural gases and other utilities.
by Mike Corley
In energy intensive industries such as aggregates, high and/or volatile natural gas prices can wreak havoc on the bottom line, not to mention the headaches incurred by management and shareholders.
While many companies in the aggregates business don’t consume as much natural gas as diesel fuel or electricity, most do burn enough gas that volatile prices and high expenditures can, and often do, have a significant impact on the company’s financials. If these volatile costs aren’t actively managed, they can lead a company to exceed budget forecasts, or worse, lower or non-existent profit margins.
Although there are many factors that affect natural gas prices, weather, natural gas storage inventories, and economics conditions, as well as the market’s perception of these factors, are the primary factors that drive natural gas prices.
Most large energy consuming companies such as those in the aggregates industry can mitigate their exposure to volatile and potentially rising natural gas costs, as well as diesel fuel and electricity costs, through hedging. Hedging allows market participants, such as aggregate producers which consume large quantities of natural gas and other energy commodities, to lock in prices and margins in advance, while reducing the potential impact of volatile and rising natural gas prices.
The primary reason that many large, natural gas-consuming companies hedge their natural gas costs is that the fluctuating price of gas can present large financial risks that have a significant impact on the bottom line. Another reason for hedging a company’s exposure to natural gas price risk is to improve or maintain the competitiveness of the firm. Very few companies are not subject to competition; they compete with other domestic companies in their sector as well as with companies located in other countries that produce similar goods for sale in the global marketplace. As a result, by having the ability to know and/or manage their future natural gas costs, many companies can establish a competitive advantage in their market.
Shifting the risk
Hedging reduces exposure to price risk by shifting that risk to those with opposite risk profiles or to investors who are willing to accept the risk in exchange for profit opportunity. Natural gas hedging involves establishing a position in a financial instrument that is equal and opposite of the company’s exposure in the physical natural gas market; the physical market is the “market” where a company procures the actual natural gas that it consumes in its day-to-day operations.
Hedging works because the cash prices and financial prices of natural gas tend to have a strong correlation. Even though the difference between the cash and financial prices may increase or decrease, the risk of an adverse change in this relationship is generally much less than the risk of not hedging.
It is extremely important to remember that the purpose of hedging natural gas is to mitigate the company’s exposure to natural gas prices, thus stabilizing the company’s natural gas costs. Hedging is not a means for a natural gas consuming company to gamble on the price of natural gas. Gambling on natural gas prices, also known as speculating, all too often produces worse results than doing nothing at all. Large gas consumers should use hedging to reduce the probability that the company will be negatively affected by volatile or rising natural gas prices. On the other hand, speculators are of the opposite mentality. Speculators bet on the direction of natural gas prices in hopes that they will be able to “buy low and sell high.”