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Energy risk management didn’t begin until the 1980’s and by the 1990’s, crude oil, gasoline, heating oil, propane, and natural gas all experienced varying degrees of success trading on the NYMEX. On the other hand, electricity was a dismal failure. Why would participants that need hedging for price exposure on hydrocarbons, not need it for a derivative product like electrical generation? Part of the problem was that, clearly, many electricity market participants simply refused to participate in futures trading. Another part was that floor traders, who make a living off volume and volatility, never moved from one of the other trading pits to the electric pit. Finally, the concept of a commodity was stretched with electricity because of the structure of the physical market. On system generation and lack of economically feasible storage led utilities to set up rules for physical delivery that required numerous variations on pricing by time and location of delivery. Regardless of the reasons, electricity futures failed to gain acceptance, virtually ending simple hedging of electricity costs as a risk management tool. So what are energy producers and users to do? Below I have offered some views on this issue. My experience has been that few people outside of the trading community understand the underlying principles of commodity trading. Commodity trading is a “zero sum” game. That means that someone loses every time that someone wins. To provide liquidity in the market, there must be a willing buyer for each willing seller. The seller is betting that the price will go down and the buyer is betting that the price will go up. One of them is wrong. Trading also adds cost for the liquidity. The floor traders (who trade ‘paper’ and have never seen an oil well, refinery, or industrial plant) need to generate volatility to trade profitably. They don’t care if the commodity goes up or down, as long as it moves and moves frequently. If gasoline traded at $0.72 per gallon, hour in and hour out, day in and day out, for six months, traders would abandon the market and eliminate the liquidity. So the cost to those trying to manage their energy risk is both the margin that the traders must generate to pay their own bills and the increased volatility that the traders need to generate those margins. This, of course, begs the question: Why does anyone, other than the traders themselves, need to buy or sell futures. The answers are supposed to be to offer price transparency and manage price risk. However, is that the case? Price transparency on “open outcry” commodities only lasts for a nanosecond as traders yell at each other and the exchange posts the most recent trade. At the end of each day, the trade prices, when graphed, often look like an EKG and raise questions as to what really was the price (the open, the close, the high, the low, the price that you got at 10:47 AM or 1:54 PM)? Further, it does not tell you what actual buyers and sellers of the physical product are willing to pay. Physical buyers and sellers pay differing prices at differing delivery points with a “basis differential”. The basis differential is constantly changing and is not concurrently publicly reported. As that differential can vary widely, from $0.50 to $12.00 at a New York City citygate for natural gas as an example, the price transparency is only what someone, perhaps a fund’s energy manager, is willing to buy or sell ‘paper’ for. This means that the price risk actually increases with commodity trading If producers (refiners, generators, or others who produce the commodity) accept these trades as prices, then they are “price takers”, not “price makers”. They are allowing non-physical market forces set their prices as floor traders and investors, not energy buyers, drive the market. ‘Price takers’ accept whatever price is offered. On the other hand, ‘price makers’ try to exert influence over the market price. Airlines and cigarette manufacturers are price makers (that is, they often get in front of the price curve such as “Delta Announces Fare Increase”); farmers are price takers (that is, livestock prices are set at either paper or physical auctions and farmers do not exert any influence over the price). Until NYMEX’s crude oil contract took off, oil producers were price makers. That is, they “posted” the price that they would accept for their crude at particular fields. Now, they are price takers, accepting the price determined by traders or investors who have no capital tied up in the physical product. Producers had been historic price takers on derivative products, such as residual oils, but had been historic price makers in both the upstream and downstream of their primary products. Natural gas, on the other hand, went from price taking (gas as a byproduct of producing oil) to price making (with a natural gas shortage in the early 1980’s) to price taking, again (with the “bubble”). When non-physical market traders and investors drive the price for one’s products, risk mitigation may be necessary to protect yourself from the resulting price volatility. If that sounds like a self-fulfilling prophecy, in commodity trading, it is. Simply put, commodity trading requires risk management and risk management requires commodity trading. It is also raises an interesting business question. If some of the largest corporations in the world (Shell, ExxonMobil, ChevronTexaco, et al) cannot tolerate this exposure to price risk, then who can? If a major utility, which can pass through market costs, cannot tolerate this exposure to price risk, who can? It is apparent that a small marketer, independent producer, or energy dependent manufacturer might not be able to withstand a sudden change in price, but major oil companies? Major utilities? It would seem that energy risk management for the major corporations may serve as a tool to avoid decision-making responsibility. That is, major oil companies that were accused of ‘price gouging’ may say that they are not the decision makers in setting price. Other large corporations may tell commissions and shareholders that they are at the mercy of market prices, which they do not control, instead of having to tell them that they sold for too little or bought for too much. This abdication of price control is especially interesting since, in the corporate world, “risk management” used to mean “insurance” and corresponding liability, not commodity trading. It is fascinating that multi-billion dollar corporations can “self-insure” (with re-insurance at a number like $200 million or higher), but that they seek (and will pay a price) for mitigation of much lower dollar price risk. This is especially interesting when liabilities, such as asbestos litigation, has driven more large firms into financial trouble than mis-pricing sales or purchases. Another argument for energy risk management is the constant desire to lower costs or get the highest possible price. Does energy risk management give consumers or producers the lowest cost or highest price? Only by chance. Energy risk management is like buying homeowner’s insurance. You buy homeowner’s insurance because you cannot afford the financial loss of your home, not because you think your home will ever be destroyed. Similarly, risk management is used not because they think prices are going up or down, but because they cannot afford the financial loss of the increased costs if energy prices rise or loss of revenue if prices fall. For everyone who bought gas futures at $6.00 and saw the market rise to $9.00, there is someone who bought gas futures at $6.00 only to see the price fall to $3.00. I have paid over $30,000 in homeowner’s insurance premiums since I bought my first home. In 30 years, I still haven’t had a house destroyed. Bad investment? No, risk management. I could not have afforded to buy a new house while also paying the mortgage on a house that had been destroyed. So, to sum up, does anyone really need energy risk management? I think that it plays a vital role for people where sudden price changes could do substantial harm to their businesses. I also believe that if there is not a physical market for your needs, it can play a role. I have a friend who builds and operates hotels. The longest mortgage for a hotel property that he can get is three years. That means that he must rollover his mortgage several times over the life of each property. To mitigate the risk of rising mortgage rates that he may not recover, he buys interest rate futures, locking in his rate for 10, 15, or 20 years. He pays higher than the three year rate (the cost of risk management), but his interest costs are locked in for an appropriate time period. This is a valuable service as mortgage bankers are not making the market for mortgages that he needs to prosper. Can you say the same about your energy risk management? If you can, you need energy risk management. However, if there is a ready physical market for the products that you need to buy or sell or if a sudden change in the cost of energy will not do long term financial harm to your company, then the cost of energy risk management is not a cost that you need to bear.