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Basic Hedging Strategies – Best Practices You Should Know

May 28, 2020

How much of my future energy requirements should I hedge forward? When is the right time to make these hedges? Which product structures should I employ to best manage my energy costs and risks?

All energy buyers face these questions when developing and implementing the strategies to meet their organizations’ energy purchasing objectives: long-term cost control and stability.

In this edition of Customer Insights, we’ll address each of the three key questions energy buyers need to answer: How much to hedge? When to buy? Which product structures should I use?

Let’s begin with the first question.

How much to hedge?

The standard approach to energy buying is to secure 100 percent of future energy requirements at a single point in time. That is, energy buyers typically employ a 100 percent forward to zero percent spot energy purchasing strategy and they implement this strategy all at one time.

Many organizations elect this approach in the hopes of avoiding cost volatility. They’re concerned spot prices or an uncertain purchasing schedule may present a significant degree of price variation – a greater degree, it is presumed, than the ”standard” approach.

At AEP Energy, we believe there are two potential disadvantages with this approach. First, entirely avoiding spot purchasing likely will result in higher costs over the long run. Over many markets and commodities, we’ve seen spot prices tend to settle below forward prices. What’s more, forward energy purchasing doesn’t come without risk or volatility (indeed risk and volatility can’t be avoided in energy, yet these factors can be managed. Prices can vary a lot from one hedge cycle to the next when energy positions are managed through multi-year contracts. This creates a significant source of volatility.

The chart below shows Locational Marginal Prices (LMPs) – spot prices, at AEP-Dayton Hub (AD Hub), from January 1, 2019 through May 15, 2020 compared to the range at which the same strip traded in the forward market in 2017 and 2018. The red line are the highest prices at which time the forward strip traded; the yellow line are the lowest prices. The result shown is every hour during 2020 thus far has liquidated below the lowest spot price your business could have possibly hedged during calendar years 2017 and 2018.

Exhibit A

What’s more, even presuming that 100 percent forward purchasing really is what’s necessary for your organization, hedging all of these requirements at a single point in time is not advisable. This “eggs in one basket” approach can result in a high degree of purchase price volatility, as one less than optimal purchase can have out-sized consequences.

AEP Energy’s recommendation is that organizations elect a blend of spot and forward purchasing. This can be tuned to your organization’s preferences, but 50 percent spot energy to 50 percent forward is a pretty good starting point or default position. AEP Energy can provide you with analytical support, looking at historical spot and forward energy price movements and ranges to help you tailor a strategy for your organization.

AEP Energy also recommends that buyers spread out hedges over time. This provides for a sort of “dollar-cost averaging” and helps you avoid shocks and unnecessary forward price volatility.

And that raises the next question.

When to buy?

The most basic approach to energy buying is date driven, with purchases scheduled at some interval prior to contract expiry, or on fixed, pre-determined intervals. While this can feel reasonable or comfortable, it is not a highly informed strategy and generally leaves the quality of the purchase decision to fate. If you’re pre-scheduled purchasing window comes when forward market prices are not favorable, you’re stuck.

Market-driven approaches are a bit more involved, with buyers trying to determine whether buying conditions are favorable based on market trends, often with input and advice from energy suppliers, consultants or advisors. Energy buying decisions made this way can be highly subjective not based on clear standards. This can also open buyers to second guessing.

To avoid bad luck through random timing, and to avoid subjective decisions which can be second guessed, AEP Energy recommends an objective approach for determining hedge timing. To that end, we have developed a strategic approach, based on objective market signals employed over defined purchasing intervals to help organizations make more informed and objective purchasing decisions.

This approach takes the guesswork and subjectivity out of energy hedging decisions and enables buyers to produce superior long-term results, all through an objective strategy that can withstand scrutiny and second guessing.

To help you upgrade the effectiveness, objectivity and defensibility of your energy buying decisions, we’ve developed a proprietary system that is based on technical market indicators and engineered to help identify favorable hedging windows and avoid unfavorable market timing.

AEP Energy’s Strategic Purchasing Program is designed to help you make objective purchasing decisions that increase opportunities for making good purchases and decreases the probability of executing purchases during unfavorable market conditions. In performance testing, our Strategic Purchasing Program has been demonstrated to generate market alerts that outperform average/random strategies 75-90% of the time (more aggressive tuning produces better outcomes on average).

The graph below illustrates how our Strategic Purchasing Program guides you with making smart hedging decisions. In the graph, notice the watch signals as they move price signals begin to dip in July 2019 and April 2020. These signals represent the signaling of model indicators that have been tuned to positively identify market conditions that are potentially favorable to hedge timing.

Exhibit B

While our propriety program is certainly suited to energy buyers of all stripes, we will work with you to develop a variety of alternative programs that are analytically driven and objective in nature. AEP Energy will help you make your buying decisions more informed, transparent and effective.

And now we are left with one last question.

Which product structures should I use?

In order to be able to execute advanced, effective, energy supply management strategies and in order to have the best overall opportunity to manage your total energy costs, it is critical that the energy product structures you choose should include both:

  • Flexibility: The product structure should have the ability to easily layer energy hedges over time, and to have a blend of forward and spot energy pricing.
  • Transparency: Non-market energy costs should be passed through. Components, such as transmission, capacity and ancillary services are costs that you are responsible for, but which are ”bundled” into (really hidden in) standard energy supply contracts. When these costs are bundled, you have no ability to manage them. Bundling provides little benefit, except for convenience, at the cost of potential missed opportunity.

Interested in learning more?

Is your organization reviewing energy purchasing structures?

Are you interested in learning how our hedging structures might be the right course for your business? AEP Energy is here for you. To learn more, contact George Deljevic, Vice President, Energy Services at gdeljevic@aepenergy. com or call George at 312-488-2238. If you are already working with an AEP Energy Sales Representative, they will happily provide more information about our hedging opportunities.

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