An energy markets perspective
The position limit regime now being considered in the U.S. provides exceptions for some hedging strategies but not others. This article describes two examples of common hedging strategies—one based on the storage of natural gas, the other on the shipment of diesel fuel from the U.S. to Europe—that energy companies think should be added back to the list.
IN THEORY, IT is easy to distinguish between speculation and hedging in the commodity derivatives markets. Speculation is using instruments such as futures and swaps to take risk in the hope of making a profit, while hedging is the opposite - using those instruments to reduce risk and lock in the profits of the underlying enterprise.
In practice, however, it is not so simple. By definition, a hedge exists to reduce risk on a related position, which means that you cannot understand the purpose of a hedge unless you also understand its connection with the related position, which in turn may be a complicated portfolio of assets and transactions.
Understanding these connections is no easy matter in the commodity markets. Commodities come in varying grades and specifications, which introduces price differentials between the benchmark used for the hedge and the physical commodity that is bought and sold. Commodities that are produced in one region are often sold in another region, which means a hedging strategy may require taking positions in multiple markets in different parts of the world. There is also a time element to hedging; it is quite common to put on a hedge today as protection against a risk that may not emerge for months or even years from now.
As a result, it can be challenging for people who are not immersed in the commodity markets to distinguish between trading that adds risk and trading that does the opposite.
That is a real concern for commodity firms, because regulators in the U.S. and the European Union are now developing new rules to limit speculation in commodity markets.
In order to make those rules work, the regulators must be extremely careful not to develop any paradigm that would treat legitimate risk-reducing use of derivatives as speculative.
The industry has been working with regulators for many years to implement a workable framework for speculative position limits for energy commodities. We have learned that providing real-world examples of commonly utilized hedging strategies can help inform this effort. This article provides two specific examples of common hedging strategies—one based on the storage of natural gas to meet seasonal demand, the other on the shipment of diesel fuel from the U.S. to Europe. Both examples show how commodity firms reduce their risks and the benefits to consumers, yet neither one of them would be recognized as hedging under the position limits regime now being developed in the U.S.
We also discuss another important principle that relates to the process of hedging. Many commodity firms are complex enterprises with operations in many parts of the world, and they often delegate hedging decisions down to the level of a trading desk, an operational unit, business division or legal entity.
This creates a challenge for implementing position limit rules that properly recognize hedging. How do we assure that the rules related to hedging are aligned with the business practices used to implement hedges? Rules that require summing up all the risks at the parent company level may seem like an effective way to determine the amount of risk that is being hedged, but that is not consistent with the business practice of delegating responsibility for hedge decisions. We discuss this more fully after the two examples of hedging strategies.
Statutory definition of bona fide hedging
The Commodity Exchange Act expressly states that speculative position limits do not apply to “bona fide hedging transactions or positions” and sets forth the basic parameters of a bona fide hedging transaction. The Act directs the CFTC to further define what constitutes “bona fide hedging transactions or positions” and states that such definition shall include a transaction or position that:
- represents a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel;
- is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise; and
- arises from the potential change in the value of—
- assets that a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising;
- liabilities that a person owns or anticipates incurring; or
- services that a person provides, purchases, or anticipates providing or purchasing.
It is important to note that the Act’s treatment of hedges does not differentiate among producing, manufacturing, processing or merchandising activities. Rather, this statutory provision contemplates bona fide hedging treatment of positions this statutory provision contemplates bona fide hedging treatment of positions that reduce the risk of a change in value of assets for each of these supply chain activities. Further, it acknowledges the use of anticipatory hedging, that is, entering into a hedge transaction prior to the completion of some or all of the underlying physical transaction that creates the risk to be hedged.
