Living Life on the Hedge – Managing Energy Price Risk

Ms. Ruchi Shukla PMT Energy Multi Commodity Exchange of India Ltd. (MCX)

Energy prices are renowned for being extremely volatile and unpredictable, various catalysts for these movements being global demand – supply, global financial outlook, international prices, weather, domestic economic activity, and geo-political factors. However, all these factors combined, what we witnessed in nearly the last 3 months has been unprecedented. The global economic and industry shutdown due to Covid 19 resulted in exceptional price movements in energy markets. Oil tumbled on intensified fears that the coronavirus will harm global growth as the contagion spread to more than 30 countries. The OPEC+ production cut was not substantial enough to prevent a further drop in oil price. And then came April 21, the black swan day, when the price of US oil swirled down into negative territory, for the first time in recorded history due to depressed demand and insufficient storage capacity.

Although currently we are facing unprecedented times, however, the increased geopolitical and weather unpredictability have more often lead to persistent volatility in energy prices.  The annualized volatility of energy prices – crude and natural gas – ranged between 20 to 50 percent over the past five years, as can be seen in Exhibit 1. However, the annualized volatility in the USD-INR ranged only between 4 to 7 percent over the said period. Forex risk has been in the limelight always and corporates have managed this risk well through varied hedging practices. On the other hand, the commodity risk exposure of businesses which has always been much greater has yet to attain due attention of the business managements.

Volatility and risk — whether from political unrest, economic changes, industrial accidents, natural calamity, or any unscheduled shutdowns, like in case of force majeure or sudden shutdowns like covid-19 lockdown, cannot be eliminated from the energy equation. Thus, generating a need for the commodity buyers and sellers to mitigate the risks of price fluctuations for fuel feedstocks, which are the raw-material inputs for industrial products. The volatile energy prices can hurt the bottom line of the industries that consume energy products as fuel feedstock in their manufacturing process.

Managing energy price risk by undertaking hedging can mitigate the shock that a user experiences from sudden price increases, enabling it to better manage costs and maintain cash flow and profitability, especially when manufacturers are unable to pass these increases on in product prices.  If an organization chooses not to manage this exposure, it often results in the organization exceeding its budget cost. However, commodity hedging is an opportunity only if companies approach it as a component of a comprehensive risk management program aimed at mitigating EBITDA-margin volatility. A more thoughtful way to hedge feedstock is to understand the relationship between its prices and the prices of end products, which reflect the costs of inputs. And as the correlations between the prices of feedstocks and products can change over time, companies should monitor and review their risk management policies and practices.

Hedging through Derivatives

Traditionally, the corporates dealing in commodities have managed price risks through ‘pass on’ mechanism or ‘contractual agreements with suppliers’. What has worked in the past has become ineffective especially with reduction in information asymmetries and most commodities moving to dynamic markets. In line with these developments, corporates across the globe have evolved and extensively utilize derivative products for hedging the risk of commodity price movements.

The availability of new financial instruments in the form of ‘commodity derivatives’ help hedge the price volatility of commodities and presents an opportunity to reduce industrial companies’ financial risk. However, many companies struggle to gain from commodity hedging because they do not utilize hedging as part of a comprehensive risk management program.

MCX Crude Oil Futures and Options – Effective Hedging tool

India imports about one-thirds of its natural gas demand. Because of its peculiar nature and lack of enough cross-country pipeline for gas transportation, natural gas is largely imported in liquefied form, that is, LNG, and majorly from Qatar.

The new contract pricing of imported LNG that is linked to crude oil, can be hedged using the MCX Crude oil contract. The MCX crude oil futures contract mirrors the NYMEX WTI crude oil price, which has more than 96% correlation with Brent crude oil price (Exhibit 2). The chart clearly brings out the correlation between Brent Crude and WTI Crude oil and Correlation between MCX crude oil and NYMEX WTI crude oil, which is 99.50 % (Exhibit 3).

BRENT – WTI PRICE CORRELATION – 97%

Moreover, the Exchange traded derivative contracts are an apt mechanism for hedging the price risks as the Exchange focuses on providing commodity value chain participants with neutral, secure and transparent trade mechanisms, and formulates quality parameters and trade regulations, in conformity with the regulatory framework.

Taking example of Glass Manufacturing Companies – As we all understand glass manufacturing is an energy-intensive industry. The bulk of energy consumed in the glass manufacturing industry comes from natural gas combustion used to heat furnaces to melt raw materials to form glass. In fact, for a Glass Manufacturing Unit energy accounts for approximately 30% of it’s manufacturing costs. Glass manufacturers mainly have an exposure towards two energy commodities i.e. Furnace oil and Natural gas. Generally, the price of furnace oil is linked to international crude oil prices and it has been observed that the these prices of Furnace oil have a healthy correlation with MCX Crude oil derivative contract prices and as such can be an effective hedging tool. Natural gas prices can be hedged in two ways – either by locking in the MCX Crude oil derivative contracts in case the same is crude oil linked pricing or by locking in MCX Natural gas contracts if the pricing is Henry Hub linked.

Energy Consumption – Furnace Oil & Natural Gas – For a Manufacturing Unit

This means that a firm using crude oil by-product, Furnace oil, as fuel feedstock, with an annual energy cost of Rs. 54 lacs, is exposed to a price risk of around Rs. 24 lacs. Similarly, a unit using natural gas as fuel, with an annual energy cost of Rs. 64 lacs, is exposed to a price risk of nearly Rs. 25 lacs.

Commodity price risk is emerging as a critical differentiator of business performance. Sharp fluctuations in energy prices create significant challenges in terms of production costs, product pricing and the resultant earnings. This price volatility as such makes it imperative for a company to hedge commodity price risks and effectively manage its financial performance. The volatility in the hydrocarbon and other energy products market can be gauged by the fact that energy prices have been on a roller coaster ride for quite some time now. Hedging is the only way out for insulating the organizations from such volatile price movements and enhancing their competitiveness and bottom lines. Managing this energy  price risk through use of ‘Exchange Traded Derivative Contracts’, which trade on a transparent and secure platform like MCX can be effective hedging mechanism.

Let’s Manage Our Risks And Live Life On The Hedge.

 Disclaimer: Every effort has been made in compiling the data/information to ensure accuracy of the content of the Article. Users may carry out due diligence before using any data/information herein. MCX will not be responsible for any discrepancies/disputes arising out of such use. This Article is made available on the condition that errors or omissions shall not be made the basis for any claims, demands, or cause of action. MCX shall also not be liable for any damage or loss of any kind, howsoever caused as a result (direct or indirect) of the use of the information or data in this Article.

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