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Merchant Power: When Hedging and Profits Collide

Does too much risk management mean leaving money on the table?

Fortnightly Magazine - June 2006

Why do energy merchants or those utilities with merchant power divisions obsess over “selling” their upside? These companies feel compelled to show steady, predictable profit streams to both the street and their stakeholders, despite the fact that they operate within one of the most volatile markets in the world. Typically, their method of achieving earnings consistency centers on the execution of complicated purchase and sales agreements that effectively lock in the price of fuel and electricity.

Don’t these contracts really just eliminate the potential positive return an energy merchant strives to achieve in the first place?

The business practice of limiting market risk runs counter to most other resource industries where investors strive to buy and sell the market risk of the underlying commodities around which the entity operates. For example, the typical gold-company investor buys equity in the company to achieve a market exposure to the price of gold as a hedge against inflation, or possibly as a speculative move to take advantage of the expected increase in gold prices. This investor would be unhappy to discover that the investment locked in the sales price of gold over the next few years, effectively nullifying the investment objectives. Gold companies that have tried this “lock-in” strategy in the past have scrambled to exit their hedges ever since gold prices started trending upward.

The Gold Standard

The bottom line is that investors in gold companies want gold exposure. The objective of taking advantage of an efficient, cost-effective gold production process runs a distant second.

Oil companies present another parallel. These global giants cannot possibly hedge the size of their market risk exposure even if they wanted to. But given their hefty profits, why would they? Just as investors in gold want to reap the benefit of increased gold prices, investors in oil companies want to realize the benefit of increased oil prices. Forget about mitigating exposure through hedging; this simply confuses the situation.

Now, consider the typical electricity generating company or energy merchant. This commodity-based business operates quite similarly to those mentioned above. These firms produce natural resources that trade within markets that are becoming more and more liquid. Yet for some reason, energy merchants eliminate as much market risk as possible through the use of both short- and long-term purchase and sale contracts. These agreements often take the form of extremely complex derivative financial instruments.

The typical equity analyst struggles to understand the underlying value drivers of such a business model given the information available to the public. Disclosures are plentiful when it comes to a company’s portfolio of generation units, retail load, or any other native energy exposure. However, information remains opaque, at best, when it comes to any long- or short-term purchase and sales contracts executed around these positions.

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