Winners and Losers in Hedging

You’re all probably sick to death hearing about the energy crisis, failed businesses, collapsed suppliers, and scared consumers. But, if we don’t pay due attention to the events that have unfolded and if we don’t learn any lessons from this crisis, then history is doomed to repeat itself.

As is the case with any tragedy – hindsight often reveals where we as a collective have gone wrong.

Or more importantly, where others have gone right.

Although there is no universal cheat code to coming through this crisis unscathed, there does seem to be a commonality between the companies that have managed to minimize exposure to the extreme volatility.

This commonality is a strong and sensible hedging strategy. Continue reading to find out who were the biggest hedging winners, and the biggest hedging losers over the last few months.

The Background to the Problem

A powerful economic recovery in conjunction with some lingering disruptions as a result of the pandemic has created an inflated market for commodities this year.

As a result of some supply chain bottlenecks across Europe and reduced renewables production – Natural Gas prices have skyrocketed to a level not seen since January of 2014.

Businesses have been affected Europe-wide – those in the utilities, chemicals, and fertilizer sectors that use natural gas have felt the pain most severely. However, sensible hedging strategies that locked in future purchases at low prices have cushioned some from a knock-out blow. Those that didn’t implement this strategy have been forced to shut operations down as prices stay high.

Natural Gas Prices Skyrocket

The utility sector has stringent government regulations in place to cap the price of energy – this means that any sharp upturn in the wholesale price of natural gas and energy cannot be immediately passed on to consumers to pay. In a scenario like this, hedging becomes of ever-increasing importance as every unit sold becomes an unprofitable avenue.

In comparison to other suppliers, EDF energy (which supplies gas and electricity to both domestic and commercial customers across the UK) has emerged as a clear winner – mostly as a result of their extensive hedging programme. Although EDF keeps their cards close to their chest regarding their gas hedging, it is known that they had already begun hedging ahead for the financial year 2021-2022 when baseload prices were well below €46 per megawatt-hour. For context, they are now in the range of €70 per megawatt-hour.

If forward prices remain above €60 per megawatt-hour until the end of the year, then the company expects a positive price effect of almost €1 billion in 2021.

Natural Gas Futures Contracts

EDF’s UK peer, Centrica, also has an extensive hedging programme –

“Given the volatility in the market, the responsible suppliers manage that volatility as we do by hedging the book so far… As an upper slope in the curve means the prices go up. You’re not really too worried about the volatility in your supply” Said Chris O’Shea, the Group CEO.

So far, this has helped the business to gain an ever-expanding market share – as they have taken over 350,000 customers of collapsed suppliers in early September. The collapsed suppliers could not withstand the changing wholesale prices as they did not implement a successful hedging strategy.

The Spanish multinational electric utility business, Iberdrola also came through the recent market volatility relatively unscathed – with 100% of their estimated price-driven output in 2021 already hedged at €75 per megawatt-hour, and about 74% of estimated output hedged for 2022 at €80 per megawatt-hour their distribution business in Spain.

Scottish Power is a subsidiary of Iberdrola operating in the UK, and they too had 100% of the two years of output already hedged at similar prices. Although the management does indeed expect prices to stabilize in the future, and even with plentiful hedging in place – they do still express extreme dissatisfaction with the high prices.

“I would like to say very clearly that utility companies like ours are not benefiting from these high prices…we are already absorbing this cost” stated Ignacio Galan, the Chairman and CEO of Iberdrola, at a second-quarter earnings call.

Similarly to Iberdrola, E.ON SE also benefitted from well thought out hedging movements in the retail market. They recently disclosed that they apply back-to-back hedging for their business-to-business (B2B) volumes without leaving any open positions while on business-to-consumer (B2C). E.ON SE’s hedging strategy spans between one to three years, covering the liquid market horizon.

Conversely, many small suppliers in the UK (especially newer entrants into the UK market) have stayed away from this practice to prioritize capturing customers through low prices, as forward commodity prices are generally higher – resulting in utility companies that hedge charging slightly higher prices.

In hindsight, companies that didn’t hedge (or hedge appropriately) have paid the dearest price – ultimately proving a fatal move as the number of collapsed suppliers in the UK is well into the double-digits.

Expanding Problems

Even out-with utility companies, high natural prices have had a knock-on effect on other industries.

Fertilizers and chemical manufacturing businesses that implement the use of natural gas in their production process have been left similarly exposed.

The US-based manufacturer and distributor of agricultural fertilizer, CF Industries Holdings, hedged their natural gas consumption through using fixed price and basis swaps. At the beginning of the year, the business had 34 million MMBtus of hedges in place. This covered 19% of their natural gas consumption, with the number rising to 26% towards the end of the first quarter of 2021.

Although over a quarter of their consumption was hedged at $3.22 per MMBtu, CF Industries Holding took the decision to halt operations at two of their manufacturing sites in the UK as a result of the sky-high natural gas prices. The UK government had to financially intervene, paying the company to resume operations at these locations.

But the issues don’t end with CF Industries Holding – Eastman Chemical, an American chemical manufacturer expecting raw material price inflation to be in the region of $200 million higher than last year.

Additionally, The Mosaic Company, which is the largest US producer of potash and phosphate fertilizer, hedged their consumption with prices set for 29.1 million MMBtu of gas. With around three-quarters of their total ammonia needs based on natural gas prices, it puts the company in an incredibly strong position for the future.

“This reinforces our competitive advantage in ammonia and the effectiveness of our hedging program to make sure that we have a number of supplies that buffer up against times like this” stated Joc O’Rourke, the President and CEO of Mosaic, during an August earnings call.

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