Although some consider Hedging to be an advanced and difficult to discern concept, the execution of hedges is in fact extremely basic. Risk managers can use futures contracts, over-the-counter swaps, call and put options, and combinations thereof to lock-in prices for a given period. This allows a company to know exactly what they will pay for their energy during that time and plan for that price accordingly. The real challenge of hedging is setting up a strategy that matches a company’s risk appetite and hedging goals.
Hedging to Mitigate Risk
Hedging is especially significant for companies that produce or consumer large quantities of energy such as natural gas, crude oil, etc. However, many companies look at hedging as a profit strategy, which it is not. The point of hedging is not to make money (nor lose money) but rather mitigate risk. That, in and of itself, is another term that needs to be defined. In some cases, a company’s risk will be based upon the price that they will purchase or sell their energy. For others, risk could be defined as the cost of opportunity to transact at a lower or higher price so that they may use saved funds to move forward with other projects or technologies.