The first most common advice is that “hedging should not include a market view”. This implies, correctly, that the ability to forecast market prices has all too frequently been proven to be non-existent. However, our advice has been that a company’s strategy should be that hedging is a necessary evil and that the potential competitive impacts of a directional price move should be the first consideration in hedging. For example, the impact of the electricity prices seen in California in the year 2000 was obvious – additional increases could make a company fail. But viewed from the competitive standpoint the other implied question is – if forward purchases are made at this price and prices go down, will the impact make the company’s products non-competitive? The EPS impact of a movement in either direction becomes important.
Now take another example – at $25/MWhr pricing, can the logical market price move downward make a company non-competitive? In many cases, the answer is that a movement down to $20/MWHr would not have a deleterious impact on EPS and a corporation’s market competitiveness. That suggests that firm forward fixed price purchases are acceptable at some price level. This implies that the company can have an acceptable market price view as it relates to the company’s overall business.
The hedging decision becomes a spectrum of decisions based on the observed market price and the competitive stance of the company. In this manner the corporation aligns the necessary evil – commodity market exposure – with its ongoing business plan.
The second most common advice is that “hedging is complicated and a non-trading company should outsource this task.” That is self-serving for the consulting and energy trading community – the former bread and butter of the energy consulting community. Should a company outsource the decisions – as opposed to the execution – of a portion of its business that may have risks equal to or exceeding the company’s total annual EPS? Outsourcing energy procurement is, in many instances, the equivalent of handing all the shareholder equity to an outsider for management. Is this reasonable?
The more sensible approach is to create a defense in depth – two or three staff members with appropriate skill sets – of internal decision capability. Especially now with the demise of the hyperactive trading community these staff members may be retained at more reasonable compensation levels. In this manner the CEO response on the 10K report regarding hedging activity and derivatives usage can be more informed and better controlled.
Outsourcing execution has been a common practice in commodity markets for years. This is the use of exchanges – and registered brokers – or OTC broker resources. Several firms have begun to offer execution and physical product scheduling as an outsource while allowing the corporation to retain all decision control. In essence, the decision is between a discretionary investment account – fully outsourced procurement – and a personally managed investment account. In many ways the issues with discretionary accounts and analyst investment advice and fully outsourced energy procurement are very similar.
With the issues of credit, counterparty reliability and reliability of advice we have seen clients becoming more receptive to our message. We hope that the increasing focus on corporate governance and responsibility will create even more receptivity.