Energy Hedging Lessons of 1996
In 1996, prices in oil and natural gas rose dramatically. End-users who
were hedged going into the bull market did well, but those who didn't were
hurt badly. Some producers hedged early in the game and were frustrated
by their inability to capture the upside in the market. Others became complacent
or averse to hedging near the end of the bull market and suffered from the
full decline once the bull market was over.
We asked energy dealers to tell us what lessons they and their clients
learned from this experience. Instead of trying to time the market, most
argued in favor of establishing a balanced hedging program-and sticking
to it. And many warned that there's plenty of energy volatility ahead.
Vice president, head, commodities origination, Citibank
This past year's highly volatile energy market illustrated the need for
employing a well-defined hedge policy. Market participants lacking a formal
hedging policy were unable to act quickly and take advantage of market conditions,
whereas risk managers with well-established hedge goals capitalized on the
available market opportunities. The most effective hedge programs had clearly
identified targets for hedging specific percentages of exposure at target
Being prepared proved invaluable in the natural gas market, where risk
managers considered the importance of the correlation between the specific
exposure and the basis upon which the hedging instrument was quoted. For
example, market volatility this past year highlighted the "basis risk"
that exists in many natural gas hedge portfolios. The NYMEX futures contract,
often used by natural gas risk managers because of its broad liquidity,
did not change proportionately with the price of specific delivery locations
at which companies operate. As a result, some hedged significantly underperformed.
The steep rise in energy prices also illustrated the benefits of using
a range of hedging tools that balance a manager's desire for commodity price
exposure with the need to reduce risk. Commodity producers faced the difficult
task of balancing shareholder desire for commodity price exposure with the
need to protect against a decline in price. By combining a mix of hedge
solutions into a portfolio, producers were able to protect against adverse
price movements while retaining the benefits of exposure to potentially
higher prices. A balanced mix of hedging strategies can reduce exposure,
protect high returns and allow for the additional exposure that shareholders
At Citibank, we continually work with clients to develop hedge policies
that address these issues. Overall, the volatility in the markets last year
reinforced our customers' need for a well-defined, consistently applied
hedge program. The program should establish clear goals (such as revenue
protection, cost control and attainment of desired ROI targets for specific
projects). The most effective programs analyze the specific exposures to
employ a variety of swaps, futures and options-based hedge solutions. Using
this as a platform, we are able to construct a hedge portfolio that best
suits our clients' goals and objectives.
Partner, risk management advisory group, Deloitte & Touche LLP
The run-up in prices, and their subsequent decline, has made many participants acutely sensitive about the importance of understanding their risk profile.
Many end-users have not historically hedged their exposures. In retrospect,
this strategy has served them well. The recent volatility, however, has
caused them to think more deeply about the objectives of their strategies
and reconsider which risks they should assume prospectively. Upon reflection,
some end-users, such as electric utilities, are deciding to reduce their
exposures to achieve more balanced portfolios. This is particularly true
for fossil-generating utilities, which are no longer protected through fuel
adjustment clauses. Of course, the specific risk-reducing actions taken
by such utilities would vary based upon the specific structure of their
The natural gas and oil producers we know generally sell their production forward for three to six months. Consequently, they did not participate
in the bulk of the upward movement in prices. Most of those producers have
not subsequently changed their strategies, but the higher prices did cause
some anxiety over lost "opportunity" profits. Our advice to clients
who may look back and second-guess their actions is that they should determine
strategies based on their earnings and cash-flow objectives, and not wring
their hands over momentary market movement.
Finally, market volatility always raises concerns about counterparty
performance. We are not aware that participants incurred significant credit
losses in the previous few months. But the possibility of such losses was
raised anew. Nevertheless, we do generally believe that credit risk remains
under-considered by many market participants.
President, Kase and Co.
One of the key lessons that our clients learned in 1996 is that they
must understand what their hedge objectives are. Some clients' objectives
were to meet their budget leaving the least amount of money on the table
that they could under practical circumstances. Later, even though they had
met their budget, some panicked when the market went against them on a mark-to-market
opportunity basis. They changed their policy in mid-stream to sell at or
above market and/or buy below market once they already had hedges in place.
Some of them vacillated between the two objectives. They have learned that
they need to set a specific set of objectives and stick with them.
They have also learned that senior management can be injurious to a hedge policy in that if the traders are hedging accruing to the program, senior
managers can demand that the hedge be lifted or changed. There have been
a number of cases that have actually been covered in the press in which
hedges were removed at absolutely the worst possible times.
Our clients have learned that if a hedge is placed in accordance with
a sound strategy they should not remove the hedge prematurely. In addition,
our clients have learned that it is best to stick with a pre-existing strategy
that is based on sound judgment and a tried-and-true statistical model.
Oil and gas forward curves exhibit consistent mean reversion characteristics,
which, along with cyclicality, can be understood well enough to inform a
hedging approach. Those who have been patient have seen that this has not
So clients have increasingly learned to view hedges over the long run
and not based on short-term capital flow. For example, if a producer puts
on a 12-month hedge in a backward market, by definition we expect some negative
cash flow in the beginning of the hedge. Therefore, it is important not
to get sidetracked by cash-flow issues.
John Sen Chu
Director, risk strategy practice, KPMG Peat Marwick
In 1996, we learned several lessons from the volatility in the energy
markets. This volatility made an impact on the basis risk in the natural
gas market, management's perception of how well information technology responded
to rapidly changing market conditions, and management's thinking about how
well-integrated the risk process was in each organization.
With respect to the basis risk in the natural gas market, the basis between the mid-continent gas market and the Hub did not hold steady. In particular,
those companies that hedged the basis risk usually fared well, and those
who had not hedged their basis risk were often the recipients of surprises.
For selected traders or "revenue enhancers" in the marketplace,
the breakdown of this historically stable basis caused substantial pain,
especially for those writing options on the basis.
These basis moves highlighted the need in trading and risk management
systems to accurately track the basis. Furthermore, some risk limit structures
and processes had not been designed to control and limit the impact from
basis risk. For those risk management structures relying on a historically
based VAR with slow reaction to the changing basis, there was realization
that VAR needed to be readjusted. In addition, trading units started calculating
VAR on the basis as well as on the overall position.
On a separate front, we observed the convergence of the natural gas and
power markets manifest itself in much soul-searching. On the one hand, there
were initiatives to compete with world-class organizations such as Enron,
Koch, PanEnergy and TransCanada. On the other hand, there was serious discussion
about how to compete with those organizations without becoming like them.
No one has the answers yet, and discussions continue. I would anticipate
that the wave of strategic mergers and alliances will continue.
All of this has some profound implications for the front-, middle- and
back-office structures, processes, analytics and information technology.
I am personally challenging my clients to think multidimensionally about new product development, front-office trading analytics and information
technology to give them competitive advantage. The old paradigm of relying
upon a trader sitting at a desk and watching the screens will likely mean
that you are a follower, not a leader.
Vice president, risk management marketing, ECT Commodity and Trade Services
First off, it's important to note why producers and end-users choose
to implement a hedging strategy at all. Unless the producer is fixing the
price on volumes greater than 50 percent of total production, or an end-user
on greater than 50 percent of energy supply, reasons to hedge should not
include beating the market. This concept is sometimes difficult to accept
in the face of price movements against hedged positions, but one that should
be embraced nevertheless. Hedges are used for a variety of reasons, not
the least of which is to gain a competitive edge. A disciplined hedging
strategy resulting in stabilized earnings will increase a company's competitiveness
and positively impact long-term financial performance.
The risk managers at Enron urge customers to identify the specific objectives they wish to accomplish. We then design hedges to accomplish those objectives.
As a result of 1996 volatility across the energy complex, we are seeing
many more customers requesting assistance in defining their risks, whether
pure commodity, competitive fuels, business cost or competing supply basin
risk, to name a few.
The volatility in natural gas (75 percent in 1996 vs. historical around
45 percent) and crude (38 percent in 1996 vs. historical around 20 percent)
points out the need for a disciplined hedging program. Since natural gas
and crude markets will likely remain or become even more volatile, the importance
of hedging is compounded. With respect to natural gas supplies, continued
concentration in the hands of fewer sellers and marketers, as a result of
the increase in strategic alliances and mergers currently abounding in the
industry, will likely lead to continued volatility, not to mention the impact
of nationwide electricity trading. These physical concentration issues already
exist in the crude markets, and we have seen what effect that has had on
It's true that end-users who neglected to hedge gas supplies in 1996
were hurt, yet 1995 saw prices at much lower levels, thereby offering opportunities
to dampen 1996 spikes. Producers who hedged gas production too early have
been criticized for limiting their upside, and those who didn't hedge are
being criticized for not taking advantage of the 1996 rally. A disciplined
hedging program resolves all of these issues, since such a program avoids
the hazards of market timing.
Coming out of 1996, customers saw overwhelming evidence that volatility
can and will affect earnings, and that there are ways to dampen the negative
effects created by a volatile market. Companies also learned another positive
lesson: they should not view their hedges separate from their overall portfolio,
as this leads to a shift away from decisions based on strategic issues to
more of a trading mentality. As stated earlier, strategic hedging should
not be instituted to beat the market.
A hedging strategy gaining popularity is a portfolio priced with one-third floating price, one-third fixed price and one-third options, all on a rolling
basis. This simple yet effective method affords protection against adverse
price movements on two-thirds of the portfolio at all times, while also
affording the ability to take advantage of positive price movements on two-thirds
of the portfolio at all times. The option component of this strategy can
be structured using a combination of a fixed-price swap and the purchase
of out-of-the-money options, or the purchase of the options exclusively.
The above percentages can be adjusted to fit a particular need, but the
disciplined approach is the key.
Managing director, Bankers Trust
The last 18 months have seen an impressive bull market in both oil and
gas. It taught consumers and producers some pain-ful lessons. While it may
seem paradoxical that both suffered, they certainly did, though not equally.
Producers learned the lesson that hedging can cost money, and most rue their
early attempts to capitalize on the rise in the market. While consumers
benefited from their hedging operations, most certainly regret that they
did not hedge more of their exposure or hedge it earlier in the bull run.
They were, in the grand scheme of things, the overall losers in the bull
market. The bull run now seems to have finished, at least in the sense that
spot prices are well below their peaks. It is interesting to reflect on
what lessons consumers and producers have learned over this period. It is
also rather sad and even a little ironic.
Consumers have learned that their failure to hedge cost them dearly.
Surprisingly, that is all they have learned, and if it seems quite obvious,
well, it is. Their reaction has, in general, been to vow that never again
will they be caught out by the market in such a fashion and to rush to hedge
prices for next winter. In the last month I have seen more concerted airline
hedging than ever before. In my 20 odd years in the market, the only faintly
comparable headlong rush to hedge that I can remember occurred in the three
weeks before the Allied forces attacked Iraq in January 1991. There are
some curious parallels between these two instances. First, the hedgers believed
on both occasions that, by hedging, they were taking advantage of a sharp
dip in the market (in both cases, spot prices had fallen some 25 percent
from their peak level). Second, both chose to hedge forward prices that
were still trading at record highs. While it is premature to suggest that
there is a third parallel about to develop-that by hedging at that juncture
both will have lost all they had gained by hedging the previous year and
then some-I would happily bet that is exactly what will happen.
Producers have learned that hedging severely dented their profits. In
the last month I have seen less producer hedging than ever before. For some
strange reason, I am again reminded of that interesting period in January
1991 when producers shunned hedging because spot prices had dropped sharply.
My confidence in being prepared to make these bets is based on several
factors, one of which I would like to share with you. While last year's
bull market occurred in both oil and gas, it did not occur at precisely
the same rate in each market. The spot natural gas market peaked in mid-December
1996, while crude oil peaked in mid-January. Between mid-December 1996 and
mid-January, spot gas prices fell by 25 percent. Since mid-January, spot
gas prices have fallen a further 35 percent. And for those of you who are
beginning to get the point, yes, forward gas prices have fallen sharply
for the last month. Hopefully, it will now seem obvious when I tell you
that gas consumers were keen hedgers in mid-January while producers have
just begun to restart their hedging programs.