HOEP is not a strategy
Originally posted on April 14, 2014
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As an account manager and electricity advisor at Bruce Power Direct I have countless conversations with energy managers, CFO’s, and CEO’s about their electricity expense. I speak with customers and prospects of all types, from Canada’s largest users, to family owned metal shops. The point of this post is to help buyers to understand the psychology and financial implications of buying an electricity hedge.
What is an electricity hedge?
For some organizations the reason they don’t purchase fixed price electricity (or “A Hedge”) is because they claim to be a ‘conservative organization’. Ironically, that is exactly the reason many of our customers choose to purchase fixed price electricity. Many companies who don’t hedge consider it ‘speculation’, however in the next few paragraphs I will outline my opinion that being unhedged is actually speculation. Being partially (50%) hedged is the only way to take a ‘neutral’ stance on the electricity price. The chart below illustrates an example:
I spoke with scores of ‘conservative organizations’ in 2013 who opted not to hedge. But in hindsight, it doesn’t seem very conservative anymore, as the price has gone up by 300% since same period last year. By not hedging your electricity price you are speculating that the price of electricity will go down. If you are neutral on the future price of electricity, according to rational economic theory, you would purchase a 50% hedge. And if you think prices are going to rise you would purchase a 100% hedge. But by having a position of 0% hedge, you are effectively saying that you think the price will fall.
We are trying to help our clients attain the best of both worlds. The value of a 50% hedge is that it gives you the freedom and flexibility to participate in the ‘downside’ if prices fall. Meaning, if you buy a hedge for 2015 today and it costs you 4.5 c/kWh now, but next week the market jumps to 9 c/kWh you will be glad you purchased the hedge, and wish you bought more. On the flip side, if the price falls to 2.5 c/kWh, you can go ahead and lock off the additional 50% of your consumption at 2.5 c/kWh, making your effective rate for 2015 3.5 c/kWh. This is considered the best of both worlds, a real conservative energy management approach. The volatility of your expected price for HOEP has been reduced by 100%. For an example, refer to the graph in appendix 2.
Now after reading the information above, what is riskier? Having no hedge at all and being completely subject to the volatile spot market or purchasing a 50% hedge? Allowing you to get the best of both worlds. If you think the price of electricity is rising (as many do), then go ahead and buy more than 50%.
But if you are neutral on the price of electricity, or know very little about it, then being unhedged, although the status quo, might not be the position you intend it to be, because you are actually betting that the price of electricity is going to fall.
Contract rate, flat at 3.7c/kWh, average HOEP of almost 7c/kWh.