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Hedge Timing

There’s no magic in dollar cost averaging.

Fortnightly Magazine - May 2012

A new approach to hedging commodity price risk appears to be gaining popularity in the natural gas and electric utility industries. This new approach, dubbed “dollar cost averaging” (DCA) by analogy to a popular personal investment strategy, appears to offer substantial cost savings over alternative hedging approaches. However, evaluating DCA critically, to locate the source and assess the magnitude of its apparent cost advantages, reveals that DCA doesn’t reduce commodity costs compared to time-averaging—a widely used and simpler approach to hedging commodity price risks.

Like the audience at a magic show, proponents of DCA have fallen prey to misdirection; because they focus on one component of commodity procurement costs, they fail to see another. Specifically, they miss the fact that the hedge cost advantage of DCA is fully offset by the balancing cost disadvantage— i.e., the cost of covering remaining commodity requirements through other forward or spot market transactions. Furthermore, not only does DCA fail to provide a cost advantage, it’s less effective than time averaging at mitigating extreme market price outcomes.

Dollar Cost vs. Time Averaging

DCA is similar to another approach that many public utilities have adopted to hedge commodity price risk, an approach referred to here as “time averaging” (TA). Under TA, utilities cover their anticipated commodity requirements through a series of forward transactions, the amounts and timing of which are set forth in a pre-specified schedule. These contracts could specify physical or financial settlement, but in either case they would fix the commodity price in advance of delivery. For example, a gas distribution company might follow a program under which it purchases 5 percent of its forecast gas requirements each month beginning 18 months prior to delivery. Thus, its open position would be 100 percent 18 months or more prior to delivery but then decline by 5 percent in each subsequent month, falling to 70 percent 12 months prior to delivery, 40 percent six months prior to delivery, and 10 percent one month prior to delivery. 1 One appeal of TA is that it limits managerial discretion and thus limits the scope for speculation, conscious or unconscious.

Note that if there were no uncertainty about its gas requirements, the hypothetical utility could eliminate uncertainty about gas procurement costs by purchasing the entire requirement immediately—the lump-sum approach. 2 However, another appeal of TA hedging is that it provides time diversification. That is, because TA hedging consists of a series of purchase or hedge transactions over an extended period of time, the cost of gas doesn’t depend entirely on the market price on a single day. In our example the cost of gas would be an average of the 18 forward purchases plus the spot purchases required to fulfill its obligation at delivery. As a result, TA carries less of the risk of regret that would accompany a one-time hedge transaction.

Whereas a TA hedging program involves a