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Hedging Delivers Cost Certainty with Bonus Potential Commitment to Price Premiums Curbs Spot Market Volatility
April, 2009
By Ryan Lang
Economic uncertainty and stock market volatility can present prudent investors with an opportunity to benefit from falling commodity prices if they’ve got a plan in place to help balance market swings. A long-term hedging strategy can provide stability and protection against dramatic price fluxes.
Hedging strategies are best viewed as a mechanism to establish cost certainty rather than gambling on the spot market price. Looking to beat the spot market often results in rash, short-term decision-making, whereas a solid hedging strategy looks to long-term business sustainability.
A variety of pricing vehicles can be used to hedge a position in the commodities markets. Many organizations choose standard fixed-price contracts, but there are other somewhat more complex instruments such as price floors, price caps and costless collars, which are a combination of price floors and price caps.
Fixed-price contracts allow organizations to purchase a commodity with a set price over an established period of time. Alternatively, floors, caps and costless collars provide upper and lower thresholds to protect against unwanted movements in one direction, yet also allow investors to enjoy favourable movements in the opposite direction.
PRICE CAPS
A price cap is also known as an option. It is an instrument that conveys the right – but not the obligation – to buy an underlying commodity at a given price.
For example, a company that manages a portfolio that consumes a large amount of natural gas might want to hedge the price of its natural gas purchases to ensure an expenditure of no greater than $7 per gigajoule (GJ). Correspondingly, the spot market price for natural gas may have dropped from $8/GJ to $6/GJ in the previous months and investors may want to position themselves to take advantage of any further price decline, but also safeguard against a price climb.
If the futures price was $6.25/GJ, a fixed-price contract would lock the investor in at that price. A price cap would add a premium to that fixed-price – let’s say an extra 25 cents, for a price of $6.50/GJ – but it would also confer the flexibility to pay much lower prices. If the spot market price dropped to $4/GJ, for example, investors would pay $4.25/GJ for natural gas – i.e. the spot market price plus the 25-cent premium.
In contrast, if the spot market price rose sharply to $8/GJ, the investor would pay a maximum of $6.75/GJ – i.e. the premium 25 cents above the originally contracted price of $6.50/GJ.
Price caps allow an organization to take advantage of market movement, while still safeguarding against price upturns. They are particularly advantageous in a downward market, whereas, if prices are moving upward, either fixed-priced contracts or price caps can be a good call.
COSTLESS COLLARS
Costless collars set both a floor and a ceiling price for the commodity being purchased. Using the example of a 25-cent premium, investors would pay a 25-cent premium to purchase the cap, but receive that 25-cent premium for selling the floor. If the originally contracted price was $6.50/GJ, the costless collar would ensure that investors do not pay more than $6.75/GJ if the spot market price rises, and sets a minimum price of $6/GJ should the market move lower.
Costless collars set a target range for commodity prices rather than the distinct price that fixed-price contracts deliver. This gives organizations budget certainty with minimal risk.
The premium prices inherent in caps, floors and costless collars can be compared to insurance. They protect against future market fluctuations. For property managers, these instruments can shape a clear, stable budgeting plan with cost certainty to protect against future shocks to a company’s bottom line.
Ryan Lang is Project Manager with 360 Energy Inc., an energy management consulting firm providing procurement, sustainable energy planning, energy reporting and energy efficiency services. For more information, see the web site at www.360energy.net <http://www.360energy.net/>.
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