PORTFOLIO HEDGING

MISTAKES Hedging Hedging is a useful practice that every investor should be aware of. In the stock market, hedging is a way to get portfolio protection—and protection is often just as important as portfolio appreciation Portfolio Manager, Individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage. Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another. Mistake to be avoided 1"We no longer hedge because we always lost money." Hedging isn't supposed to be a source of income. A well-designed energy hedging strategy should, depending on whether you are a producer, marketer or consumer, provide one or more of the following: Cash flow certainty Ability to lock in a profit margin(s) Protection against decreasing prices Protection against increasing prices Revenue certainty 2. "We consistently generate profits on our hedges." If the goal of your hedging strategy is to generate profits you have become a speculator. There are some exceptions, such as trading around assets (storage, transportation, etc.), but they are the exception, not the rule. Speculating is fine if it is your true intent and you recognize it as such, but speculating is not a form of hedging. 3. "Go ahead and hedge but don't make any mistakes." The vast majority of hedging mistakes are the result of a poor or nonexistent energy risk management policy and/or the lack of a sound hedging strategy(s). Most hedging mistakes can be avoided if you take the time and effort to create a proper risk management policy and develop and implement strategies that allow you to meet your hedging goals and objectives. 4. "Our management team can't agree on whether we think prices are going up or down this year." Hedging decisions shouldn't be made solely, or even mostly, based on your view of future prices. If it were so easy to predict energy prices, we'd all be relaxing in the islands, counting our money. 5. "We do hedge, but not when we think prices are going to move in our favor." What happens if you don't hedge and prices move against you? Do you wait a little longer and hope for a reversal? What do you do if the trend continues to move against you? 6. "We're going to wait and see what energy prices do over next few months." Again, what do you do if/when prices don't move in the direction that is not in your best interest? Do you continue to wait or do you "cry uncle" and mitigate your risk? 7. "Sometimes we hedge 100%, sometimes we don't hedge at all. It depends on our view of the market." What happens if your view is incorrect? What type of impact does an incorrect view on the market have on your cash flow and profit margins? 8. "We hedge when we see good opportunities." What if it takes months or years for a good opportunity to present itself? What do you do if there is a significant price move in the "wrong" direction while you are waiting on that good opportunity? 9. "We only hedge when we have a strong view on the market." We often have a strong opinion about the market ourselves, but if your strong market view is incorrect, what do you have at the end of the day? Declining revenues? Declining cash flows? Declining profit margins. Increasing cost of goods sold? 10. "We don't speculate." If this is indeed true, congratulations, you're in the minority. If not, it's probably a good time to review your hedging strategies and risk management policy and determine, if you are, in fact, comfortable with your (speculative) positions and the risks associated with said positions.