Know the differences between hedging, speculating

March 11, 2009 By    

The propane season of 2008-09 will be one for the books for a lot of reasons.

Driven by unpredictable events in the past year, Mt. Belvieu spot propane rose to nearly $2 per gallon and then dropped to less than half of the high – all in a matter of a few months. As a result, this past season also will be remembered for the stories of those who chose wisely in buying propane supply and those who did not.

The terms frequently used when buying propane supply are “hedging” and “speculating.” Often we talk in terms of hedging our supply by buying propane to meet future needs. However, after propane is bought, the end result can involve more risk than before. Increasing the risk in how we buy propane is an example of speculation.

The two terms, “hedge” and “speculate,” are often interchanged as if they mean the same thing – when, in fact, they are polar opposites. Making the mistake of thinking you’re doing one thing when you’re actually doing the other has cost individuals their jobs and companies their existence.

Speculation – Taking large risks, especially with respect to trying to predict the future; gambling, in the hopes of making large returns. Speculation involves risk and uncertainty, but also lures with the chance for reward or a big payday. Some industry examples are:

1. Any purchase of propane where price is determined and no corresponding fixed-price sale has been made.
2. Selling fixed-priced contracts to customers without buying equal quantities of fixed-price supply.
3. Establishing a cap price to customers without making corresponding price and volume purchases.
4. Selling fixed-price contracts in which the gallons to be delivered are not certain.
5. Anytime you cannot account for the volumes that have moved on a fixed-purchase leg of a hedge or you have lost track of the gallons delivered.

Hedge – Any technique designed to reduce or eliminate financial risk. A true hedge involves the sale of a specified amount of propane to be delivered at a specific price to a specific location at a specified date, combined with a corresponding purchase of equal volumes of propane to be delivered at the same location during the same time period at a specified price. The purpose is to ensure that two corresponding, opposite positions are netted to each other and are neutral to the market movements – because they both move together as the market moves. Hedges work well in retail propane distribution businesses because the primary goal is to make a targeted margin off propane sales, not off market movements.

Our emotional side likes to take risks and wants big paydays. Speculation is more fun. On the other hand, hedging is about numbers matching up and being reconciled. It also involves accurate and timely accounting of volumes bought and delivered. The conservative, logical side understands that a true hedge makes sense, yet managing hedge positions requires constant attention to detail. Even when a hedge works perfectly, we complain because part of the hedge lost money.

Aside from an accident occurring in our operations, our biggest, absolute risk lies in our decisions in buying propane supply. Consider this advice:

1. Be honest with yourself as to whether propane purchase decisions or fixed sales programs truly reduce risk or if they are increasing your risk.
2. Establish in your company the accounting and reporting systems and expertise to generate daily reports on positions and deliveries that give you a snapshot of your total risk position.
3. Manage your positions and balances of fixed sales and purchases on a daily basis.
4. Make purchase decisions based on facts, not impulses.

Speculation can be a great tool when done in a calculating, measured way. Just don’t fool yourself into thinking you are hedged when, in fact, you are speculating.

Carl Hughes is senior vice president of business development for Inergy LP. He can be reached at Chughes@InergyServices.com or 816-842-8181.

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