Does too much risk management mean leaving money on the table?
Andy Dunn is a managing director at Risk Capital Inc., an energy risk-management consulting firm. He provides risk measurement, valuation, and business-process expertise to a wide range of energy-trading and risk-management firms worldwide. Contact him at firstname.lastname@example.org.
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.