Energy + Risk = Why Hedging Matters
Cargill Risk Management gave an overview of the new era of price risk management in Mexico December 2018. In that article, we talked about the change that the market will emerge into a free-pricing environment in 2019. We also stated that importers, distributors and retailers could expect to bear risk in price fluctuations in their own books. In this article, we provide an overview of some of the industry’s immediate questions and follow up with examples of how a risk management strategy may help a company mitigate risk.
Moving to a free-pricing environment
With the change to a free-pricing environment, the industry wanted to learn if it should hedge and how that mechanism worked. Common questions included: What risk will I have? We haven’t seen a change like this in a very long time – how will this affect me? Why bother hedging? Hedging seems complicated. How would I even start? The first two questions are ones that risk managers need to consider for their specific businesses. We will unpack the other two questions below.
Why bother hedging?
Oil is one of the most liquid markets in the world, but it can have significant volatility. The basic principle of hedging is that it helps protect your margins. In short, it gives you more predictability and small movements in your margins – ultimately allowing you to focus on the rest of your business.
Hedging seems complicated. How would I even start?
Hedging doesn’t have to be complicated. The first step is understanding what risk is and what risk exposure can be hedged.
There are many sources of risk – you can see some of those here. Cargill Risk Management isn’t here to control the source of the risk, instead our role as an over-the-counter (OTC) provider is to help customers control what they can.
Risk exposure that can be hedged must be highly correlated to a transparent, tradeable and liquid index.
- A 100 percent correlation is ideal – and possible if the same index is referenced in all contracts – but more than 80 percent is preferred.
- It must be transparent, meaning that market prices are published at least daily by an independent entity.
- It needs to have the ability to be freely traded by on- or off-shore counterparties.
- It must have a minimum level of relative liquidity
The objective of hedging is to protect your margins from adverse movements in market price.
If you are looking for more resources to help you understand hedging, reach A Glimpse Into the History of Hedging and Is a Hedge Always a Hedge?
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