Hedging and how it affects price

What is hedging?

Hedging in the energy market, is a method in which energy suppliers are able to purchase energy in such a way that minimises any risk posed by price volatility of energy. This is astonishingly, the simplest definition that could be thought of. We will discuss in more detail how hedging works, and why it is so commonplace – and hopefully by the end of the article, the original definition will make a little more sense…

In the business-world, it is an absolute no-brainer to keep costs as low as possible. If you fail to do so then your profit margin will be eroded to zero, as-well as competitors managing to offer lower prices for similar products. So, why would it be any different for energy suppliers?

As the energy market is incredibly price-volatile and influenced heavily by external market factors, there are opportunities presented to dramatically lower costs. As the market rises and falls, energy suppliers will watch until the right time to strike. As the cost of energy dips to a certain level, suppliers will pounce and purchase.

Why don’t energy suppliers purchase energy all at once?

You may be thinking to yourself – why don’t they just purchase all of their energy needs at the lowest point in the dip to maximise profits? Well, it is easy to say that from a position of hindsight. This strategy of hedging (buying small amounts here and there) helps to mitigate against the risks presented by price volatility.

If an energy supplier were to buy their entire year-worth of energy at one particularly attractive price, they could definitely turn a handsome profit by selling it onwards to customers. But what if the market continues to dip?  The supplier who initially thought they were getting in on a pretty good deal suddenly has a vast amount of comparatively more expensive energy to get rid of.

It’s simply not possible to return energy once it has been bought and paid for, so the supplier will try to claw back as much of the costs as possible by selling it onwards to customers. This will leave them taking a huge financial loss on their energy for the year.

This is why energy suppliers will implement hedging. It allows them to roll the dice many times over and hope to score a 6, rather than risking it all on one big roll. It allows the ability to take smaller short-term profits consistently, as opposed to one big gamble.

Although there are people paid handsomely to attempt to predict the energy market, they do not always get it right 100% of the time. Hedging allows energy suppliers to capitalise on all the times they do, while not leaving them too vulnerable in the situations they don’t.

How does hedging effect my business energy bills?

You may be forgiven for thinking that these energy suppliers that target low energy prices will pass the benefits on directly to you, the customer… This isn’t strictly true.

Many businesses have cottoned onto the volatility in the energy market and how energy suppliers are able to take advantage of this. These businesses looked to see if there was a correlation between their monthly billing prices and the price-level of the energy market. They noticed that even when energy market prices were at monthly lows, they could not see a corresponding dip in their energy prices.

This is directly as a result of hedging. Hedging allows for energy suppliers to pre-purchase energy months in advance and continuously top-up throughout the year in response to demand. Because of this, it is very rare that the energy supplied to your property this month has actually been purchased this month. Energy market hedging halts any of the benefits in price-volatility to be directly passed on to the customer.

Hedging - Making Sense of Price Volatility
Making Sense of Price Volatility

So, energy market hedging is only positive for energy suppliers?

Just because the benefits of hedging aren’t directly passed on to the customers, does not mean that there are none.

If hedging was not common-practice, then energy suppliers would look for another financial safeguard to protect themselves against the risks of price-volatility. It is likely that this would take the form of a ‘risk premium’, a monthly payment to cover the risk involved with supply. So – there is one indirect benefit from hedging.

Secondly, hedging allows for things like ‘fixed-term, fixed-price’ contracts. These contracts are very important for small to medium-sized businesses, who rely on the financial security and strict-budget control benefits. Knowing exactly how much you will be paying each month for energy is another indirect benefit from hedging activity.

Hedging clearly benefits both customer and supplier in this scenario! Just because your monthly prices do not directly reflect the level of the wholesale energy market, does not mean you are not receiving any benefit.

Common Questions

What is Energy Hedging?

Energy Hedging is a procurement strategy that protects energy suppliers from the risks of price-volatility in the wholesale energy market. They buy in small amounts, frequently. This allows them to take advantage of any dips in price while not leaving themselves to vulnerable to further falls in price.

What is an example of hedging?

An example of hedging would be in the energy market. Hedging is incredibly commonplace in the wholesale energy market, as suppliers compete against one another to find the best-priced energy (pricing is updated at 30-minute intervals). Suppliers will agree contracts to fix price at a certain level, or over a certain period of time whilst procuring energy.

What is the definition of hedging?

A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset – Investopedia

What is hedging in oil and gas?

Although these industries are quite different – hedging follows the same basic principles. Many companies who purchase on the wholesale market are left vulnerable to price volatility. Hedging works in the same way here as it does in the energy market. Companies will purchase either oil or gas for a fixed price at a certain level or period of time, reducing vulnerability to further price volatility.

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