The Basics of Energy & Commodity Risk Management ETRM-CTRM- Hedging Strategies – Blog 1 of 2
Companies that are exposed to commodity price volatilities often find themselves looking for ways to mitigate the price volatility in order to better predict or mitigate their commodity price exposure into the future. This is easier said than done, especially in today’s wildly volatile marketplace. Nonetheless, companies need to find ways to manage this exposure for many competitive reasons. Many look to consultants that specialize in energy trading and risk management –ETRM or commodity trading and risk management –CTRM to provide guidance in establishing a basic risk management (margin limits etc.) and hedging strategy. Once policy and procedures are defined companies can begin to execute the hedging strategy.
Basic hedging strategy involves execution of exchange (NYMEX or CBOT) financial contracts that offset the current physical position or lock in the price for which the physical commodity will ultimately be delivered or consumed. For example, a Utility that comsumes physical natural gas to run a power plant is exposed to the natural gas futures price for their electricity generation. This price exposure can be mitigated or locked in by buying futures contracts. Once the contracts are purchased the price is mitigated or locked in and the ETRM process kicks in. What that means is that there is now a contractual financial price exposure or financial position that needs to be managed. Financial exposures are much like the physical exposure with profits and losses must be tracked as losses can quickly become a financial burden in the form of margin requirements.
To manage margin requirements companies must have liquid assets in the form of cash on hand as an upside down or out the money hedges becomes an exposure in the form of margin calls and liquid cash must be readily available to cover this call. The ETRM-CTRM cash flow at risk –or CFaR metric is a measurement of that margin call. It is important that a company know at all times what that margin or cash obligation is.
So why would a company enter into a hedge that becomes a cash burden. Remember entering into a hedge position is a way to lock in potential future exposure to a commodities volatility, however just because you think prices are going up in the future does not necessarily mean that they will. Should prices slide and not rise, for example the mentioned Utility “buy position” becomes a loss margin call cash exposure. The position now has a loss associated with it.
So why would a company do this?
More to come on Blog 2
About Pioneer Solutions LLC:
Pioneer Solutions is a global provider of commodity management software, CTRM-ETRM products and emissions compliance -EMIS solutions serving some of the largest utilities in the US and Europe.
Voted “Preferred ETRM-CTRM System” by our clients and peers, Pioneer Solutions’ “TRMTracker” is a FARRMS advanced architecture based solution that is changing the marketplace with its all web-based comprehensive energy and all commodity trading & risk management (ETRM-CTRM) software features. Built from the back-office forward by industry professionals, TRMTracker features the most comprehensive back-office available in the ETRM space with its advanced (FARRMS) formula-driven settlement and billing engine including the top-rated derivative hedge accounting automation module available.
FARRMS’ flexible and malleable, template and formula-driven architecture requires no coding to configure and maintain thus lowering the total cost of ownership while increasing the longevity of the platform’s ability to meet current and future demands. This organically built; work-flow driven architecture supports the straight-through processing of deals, from deal capture to risk management, scheduling, settlement and accounting processing (GL entries). TRMTracker’s risk engine offers robust, all web-based OLAP (slice & dice, drillable) reporting of all ETRM-CTRM at risk models including enterprise risk metrics like CFaR, TPE, PFE, EaR, Credit Risk Management -CVaR and more!