To Hedge or Not To Hedge?

Updated: Apr 5, 2019

To hedge or not to hedge – that is the question many risk managers have asked themselves after a tumultuous 2018, which saw wild forward hedge pricing run-ups in ERCOT ahead of the summer and in the north-eastern markets prior to the winter.

At face value, hedging is a risk management strategy deployed by retailers and asset owners to lock in pricing for some fixed quantity ahead of peak seasons where prices are likely to express volatility.

For retailer suppliers, hedges are needed to protect against wholesale energy prices movements on your fixed price book of business and variable price contracts. However, they can also cause large revenue fluctuations in the event that the peak demand season does not produce sufficient price volatility. This second outcome is the reality that many retailers are dealing with as we exit a largely lackluster winter in terms of price volatility compared to market expectations prior to the start of the winter demand season.

What must be kept in mind at this juncture is that hedges are not intended as speculative trades – and no retailer should be adjusting their hedging strategy to speculate future market conditions. To the contrary, hedges should in fact take the risk of future market conditions off the table.

The one question that does come up during periods of heightened forward curve volatility is the timing of your hedges. Historically, we have seen large forward price movements over a 2- 3 week period that, with perfect timing a week early, would save you some hedge costs. Short of having the crystal ball and timing the market perfectly, what can a risk manager do heading into these volatile seasonal demand periods?

One starting point is to make sure you understand current hedge values in terms of their relative value against their historical range. The conversation centers around how many chances you have had to hedge at a better price, rather than a conversation of where prices can end up in day-ahead settlement (leave that to the speculators). The chart below shows the PJM West Hub On-Peak product’s current valuation against both its 13-week and 52-week historical ranges.

Summer 2019 months are close to their 13-week lows and are in the middle of their 52-week ranges. This is a simple starting point, but does give a risk manager insight into current market conditions and they could conclude that there is value in today’s forward curve compared to the last fiscal quarter to hedge PJM West Hub. Alternatively, they can also conclude that it’s only in the middle of its 52-week range and there might be more room for the summer terms to trade down over the next few months. The execution strategy would need to consider your risk tolerance and risk policy requirements. While waiting could extract additional realized margin from your hedges, it will not come without additional risk.

The next step to help you put today’s current valuation in its historical context requires access to a database of clean forward curve data for the zones you need to hedge, as well as accurate forward marks calibrated to the latest power gird conditions. TRUELight provides this crucial data to our clients to support tactful hedging strategies with proven success. Being registered members with the ISOs, active wholesale-to-retail market participants, and an independent third-party source is a combination that allows us to deliver the most accurate and unbiased support. (Email for more on portfolio and risk management expertise).

As you begin to layer in intelligence from current energy market fundamentals, in addition to historical data, there are also structural changes we are seeing in the majority of the US power grids that need to be taken into account. This insight should allow you to adapt the story told in the historical data to encompass a more holistic view of current and upcoming market conditions. Another simple example is how much attention is paid to the Natural Gas Storage levels throughout the fall, which lagged well below the 5-year minimum prior to the demand season. This alone did not produce volatility, but when overlapped with the unseasonable cold that hit in early November, the combination did prime the market to run prices up much higher than expected.

In short order, it is extremely difficult to predict forward market movements against settled prices. To help navigate today’s market conditions, you should depend on clean and reliable historical data on forward marks, and take the advice of trusted energy market intelligence experts to put this historical view into context against changing market conditions as the energy industry continues to rapidly evolve.

Email to learn more about the Portfolio & Risk Management and Energy Market Intelligence Support discussed in this week’s post. We pride ourselves on delivering the best data and market insight in the industry, and we would love to work with you!

Stay tuned for PART 2 of this post, where we will address structural changes taking place in ERCOT that are expected to drive extreme volatility for summer 2019.

© 2019 by TRUELight Energy LLC

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