What it means
The main instruments are futures, forwards, swaps and options. Futures are standardised contracts traded on an exchange with daily margining, while forwards and swaps are negotiated directly between two parties and tailored to the volumes and dates a business actually needs.
Options give the right but not the obligation to transact at a set price, which is why they behave more like insurance. Energy prices are among the most volatile costs a company faces, and that is the whole reason this market exists.
A haulage firm, an airline, a smelter or a bakery can see its energy bill move by a third in a year through no decision of its own. Fixing the price in advance turns an unpredictable line item into a budgetable one, which protects margins and makes pricing to customers far easier.
In practice most hedges settle in cash while the physical purchasing carries on as normal. The company keeps buying gas or fuel from its usual supplier at whatever the market charges, and the derivative pays out or costs money to offset the difference against the agreed fixed price.
The two flows combine to produce the effective price the business intended to lock in. Three cautions matter, beginning with basis risk, which arises when the index used in the contract does not move exactly in line with the price the company actually pays and leaves part of the exposure uncovered.
Exchange-traded hedges also require margin, so a winning physical position can still create a cash call on the derivative. And a hedge that ends the year showing a loss has usually done its job, because the saving appeared in the physical bill instead.
In practice
Real-world examples.
Example
An airline pays a $2,000,000 premium for call options capping jet fuel at $2.80 a gallon on 12,000,000 gallons. Prices rise to $3.30, so the options pay ($3.30 - $2.80) x 12,000,000 = $6,000,000, a net benefit of $4,000,000 after the premium. Had prices fallen, the airline would have lost only the premium and enjoyed the cheaper fuel.
Example
A wind farm signs a power swap fixing electricity at $48 per MWh on 200,000 MWh of expected output. Its revenue from that volume is $9,600,000 whatever the spot market does, which is what allowed its lenders to size the project debt. The certainty is worth more to the owners than the upside they gave away.
Example
A haulage firm hedges diesel using heating oil futures because no liquid diesel contract suits its volumes. Diesel rises $0.22 a gallon while heating oil rises only $0.17, so $0.05 a gallon of the increase is unhedged. On 3,000,000 gallons that basis risk costs $150,000.
Formula
Calculation
Swap settlement = (floating average price - fixed price) x notional volume. The hedger receives the payment when the floating price is higher than the fixed price and pays when it is lower.
A ceramics manufacturer burns 120,000 MMBtu of natural gas a year and fixes the price at $3.50 per MMBtu using a swap. The floating index averages $4.20 over the year, so the swap pays the manufacturer ($4.20 - $3.50) x 120,000 = $0.70 x 120,000 = $84,000.
The physical gas bill was $4.20 x 120,000 = $504,000. After the $84,000 swap receipt, the net cost is $504,000 - $84,000 = $420,000, which is exactly $3.50 x 120,000, the fixed price the manufacturer set out to achieve.Case study
Seen in the real world.
Northmoor Glassworks is a fictional manufacturer, used here as an illustrative example. Its furnaces consumed 400,000 MMBtu of natural gas a year, and after a painful winter the board approved hedging 70% of that volume, or 280,000 MMBtu, at a fixed $3.20 per MMBtu.
Spot gas averaged $6.10 that year. The swap gained ($6.10 - $3.20) x 280,000 = $812,000, and the unhedged 120,000 MMBtu cost $6.10 x 120,000 = $732,000. Against a fully unhedged physical bill of $2,440,000, Northmoor's net gas cost was $1,628,000, and the hedge was the difference between a thin profit and a loss.
The following year spot collapsed to an average of $2.40 while the hedge was set at $3.10, so the derivative lost ($2.40 - $3.10) x 280,000 = $196,000 and the net gas cost was $1,156,000. Several directors wanted to scrap the programme, until the finance director pointed out that the company had still paid less than the previous year and that nobody cancels their fire insurance in a year without a fire.
Watch out
Common mistakes.
- Judging a hedge by whether the derivative made money, rather than by whether the combined physical and financial cost matched the budget.
- Hedging a volume larger than the business actually consumes, which turns a cost protection into an outright speculative position.
- Ignoring margin requirements on exchange-traded contracts, so a favourable physical position is accompanied by an unexpected cash call.
Questions
People also ask.
Do I have to take delivery of the oil or gas?
Almost never, because the great majority of energy derivatives are settled in cash against a published index and closed out before the delivery date.
What is basis risk?
It is the risk that the index in the contract and the price you actually pay move differently, which leaves part of the exposure uncovered even though a hedge is in place.
How much of my energy use should I hedge?
There is no universal answer, but many industrial users cover somewhere between half and three quarters of forecast volume, keeping a portion floating so they still benefit if prices fall.
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