Beyond the Barrel: Managing Price Risk in Energy Markets

The Reserve Bank of India, in its December 2022 issue of its Financial Stability Report has, once again, focused on volatile commodity prices as a source of risk in the Indian economy. The central bank categorizes this risk in the \'high risk\' category, ranking it the 4th biggest risk (out of 32 identified risks) in the Indian financial system.

Till recently, most businesses managed to withstand the commodity price movements, through these rudimentary methods, as the swings were more often temporary and cyclical and they had long-term contractual agreements. However, with structural changes shaping up the global commodities economy, the broad-based volatility in commodity prices, is not only affecting short term profits, but also long-term planning and investment. Hence the need for undertaking commodity price risk management in a more structured manner. There is a need for the corporates to manage risk for ensuring stability, resilience, and sustainable growth in an unpredictable environment. Risk management allows companies to identify potential threats, reduce vulnerabilities, and capitalize on opportunities to ensure long term success.

Impact of Commodity Price Movements

Volatility in commodity prices impacts market participants differently irrespective of where they stand in value chain. To put out in simple words,

A fall in commodity prices can:

• Decrease sales revenue for producers, potentially decreasing the value of the organisation, and/or lead to change in business strategy.
• Reduce or eliminate the viability of production mining and primary producers may alter production levels in response to lower prices.
• Decrease input costs for businesses consuming such commodities, thus potentially increasing profitability, which in turn can lead to an increase in value of the business.
• Affect inventory management solutions as there is a direct impact on earnings in case of fall in the value of inventory.

A rise in commodity prices can:

• Increase sales revenue for producers if demand is not impacted by the price increase. This in turn can lead to an increase in the value of the business.
• Increase competition as producers increase supply to benefit from price increases and/or new entrants seek to take advantage of higher prices.
• Reduce profitability for businesses consuming such commodities (if the business is unable to pass on the cost increases in full), potentially reducing the value of the organisation.
• Directly have an adverse impact on input cost with prices of raw materials going up significantly.

While we talk of commodities, in the world of energy, uncertainty is constant, and managing price risk is becoming an essential for survival. Going ahead, strategizing energy price risk management may become the backbone of business houses, especially in terms of creating resilience and enabling them to thrive against uncertainty.

Oil prices are heavily influenced by global economic conditions. Factors such as economic slowdowns, disappointments over stimulus packages, recessions, or changes in consumer demand can lead to decreased oil consumption, which in turn affects prices.

OPEC (Organisation of the Petroleum Exporting Countries) plays a significant role in influencing global energy prices through its production quotas and collective decision-making among member countries. However, OPEC\'s influence also gets offset by external economic factors heavily influencing market behaviour. Political instability in key oil-producing regions can disrupt supply chains and impact pricing dynamics. While OPEC may attempt to manage its output, geopolitical events can create uncertainty that leads to fluctuating prices independent of OPEC\'s actions.

On the other hand, the rise of non-OPEC oil producers, particularly the United States with its shale oil production, has significantly increased global oil supply. This surge means that even if OPEC decides to cut production to raise prices, the additional supply from non-OPEC countries can offset these efforts, keeping prices lower than desired.

The interplay of these geopolitical factors-regional conflicts, OPEC and OPEC+ decisions, and global economic health-continues to create volatility in oil prices, making it essential for stakeholders to stay informed about these developments.

With this, hedging energy prices emerges as a vital strategy for companies looking to stabilize costs, enhance financial planning, and maintain a competitive edge.

Hedging - A brief overview

Hedging is a method of strategically using financial instruments to offset the risk of any adverse price movements. Hedging plays a crucial role in the industry today for proper risk management and to protect shareholder value. Companies are assessed by shareholders and investors based on how strong their hedging strategy is. Derivative instruments such as forwards, futures, swaps and options are examples of some of the instruments used by companies to mitigate the risk and hedge the physical positions/asset. Essential benefits of hedging:

• Cost Predictability
• Enhanced Investment Decisions
• Improved Cash Flow Management
• Competitive Advantage
• Regulatory Compliance and Sustainability Goals

Fitch Ratings examined the hedge books of 27 U.S. and Canadian oil and gas exploration and production (E&P) companies at 3Q23 to assess their hedge coverage for 2024 and the implications for credit and price risk. The average 2024 oil hedge coverage for oil-focused producers is 39%, while the average 2024 gas hedge coverage for gas-focused producers is 48%. Many investment-grade (IG) oil and gas producers, along with a few high-yield (HY) producers, remain fully unhedged throughout 2024, which brings added downside price risk, particularly for those with weaker balance sheets or who are digesting debt-funded M&A deals. (Source: Fitch Ratings website)

Sustainable Businesses

Sustainability as a concept is linked generally only to environment. However, when we talk of commodity and energy insecurity, overcoming these insecurities becomes a question of survival first and then sustaining these businesses.

Infact, sustainability is often broken down into three pillars: economic, environmental, and social-also known informally as profits, planet, and people. As a result of volatile commodity prices which is fuelled by population growth, climate change and growth prospective; companies face a significant exposure. The concept of \'economic sustainability\' focuses on conserving the natural resources that provide physical inputs for economic production, including both renewable and exhaustible inputs. Industries having exposure to these natural resources as feedstock cannot reduce the consumption but can manage their price risk efficiently in a volatile environment by hedging through commodity derivatives traded on exchanges. In Indian markets, price risk management has most often talked only in terms of forex prices. However, a quick run through Graph 2 will tell us how far-fetched the gravity of commodity price risk management is. One side is 4-5% average forex volatility which we tend to manage. On the other side is oil & gas price risk, where the average annualized volatility is around 40-50%, and many a times the exposure to this price risk is kept open-ended.

Energy Derivatives - Effective risk management instruments

The availability of financial instruments, particularly energy derivatives like crude oil and natural gas contracts on regulated exchanges such as MCX, help mitigate price volatility by serving as effective risk management tool. These highly transparent and liquid contracts attract various financial sector participants, including algorithmic traders, AIFs, FPIs, and MFs, who absorb risks faced by value chain participants and provide essential liquidity for hedging.

Fuel feedstock and crude based raw materials account for bulk of the manufacturing costs across various industries like the automobile, glass, metals & metallurgy, fertilizer, paints, etc. The robust and liquid crude oil and natural gas futures and options contracts are available to the corporates for hedging their input costs through the MCX Exchange Platform. These cash settled contracts mirror the price movements in the international market. Additionally, these contracts allow for hedging international exposure in INR-denominated contracts, offering a natural currency hedge.

The Exchange provides buyers and sellers with price insurance that can be integrated into cash market operations. Trading Exchange contracts can improve the credit worthiness and add to the borrowing capacity of natural resource companies, thus augmenting the companies\' financial management and performance capabilities.

Energy price risk management can emerge as a critical differentiator of business performance. The global conglomerates from producers (British Petroleum, Shell), refiners, Airlines (Southwest Airlines, Air France-KLM, Lufthansa), glass companies (Saint Gobain, Duralex), fertiliser companies, etc. and other core sectors have been committed to hedging actively in energy derivative instruments, thus enhancing their competitiveness and in-turn their bottom lines.

Hedge Accounting

Transition to Ind AS regime is a landmark for the Indian industry, bringing about a paradigm shift in reporting & disclosures besides improving the transparency of financial statements, benchmarking them to international standards and accounting practices. While hedging mitigates price risk, the associated accounting norms requires organizations to record MTM gains and losses in each reporting period, leading to earnings volatility in financial statements. Hedge accounting governed by IndAS 109 addresses many challenges by providing stability in profitability reporting thereby minimizing the volatility in bottom-line reported in financial statements.

Hedge accounting is basically a technique that modifies the normal basis for recognizing gains and losses on associated hedging instruments and hedged items, so that both are recognized in Profit and Loss Account (P&L) or Other Comprehensive Income (OCI) in the same accounting period. Ind AS permits an entity to apply hedge accounting to represent the effect of risk management activities that use financial instruments to manage exposures arising from risks that could affect profit or loss (P&L) or other comprehensive income (OCI).

The basics of hedge accounting have not changed over the earlier regime. However, change as mandated by Ind AS 109 lies in widening the range of situations to which one can apply hedge accounting. Under Ind AS regime, hedge accounting can be basically applied to almost all hedge relationships, as the rules are now more practical, principle based and place greater emphasis on an entity\'s risk management practices. They provide more flexibility and allow corporates to apply hedge accounting where previously they would not have been able to. As a result, this is an opportunity for corporate treasurers and boards to review their current hedging strategies and accounting, and to consider whether they continue to be optimal in view of the new accounting regime.

Ind AS 109 has introduced a new concept of \'economic relationship\' and requires the existence of an economic relationship between the hedged item and the hedging instrument.

Ind AS 109 also relaxes the requirements for hedge effectiveness, removing the bright line test of 80-125%. In the new era of Ind AS 109, an entity needs to demonstrate that an \'economic relationship\' exists between the hedged item and hedging instrument on a prospective basis. This change could result in more hedging relationships qualifying for hedge accounting based on the actual risk management strategies of the company. For example, a vast majority of petrochemical manufacturers employ naphtha cracker units for cracking naphtha into polymers and olefins. Since naphtha is a product from the fractional distillation of crude oil, its price movement is highly correlated with that of crude. Hence Brent and WTI Crude hedges are most common proxy hedges due to its economic relationship with naphtha.

Conclusion

In an era of heightened energy price volatility, hedging has become an indispensable tool for businesses seeking to navigate the complexities of the energy market. By implementing effective hedging strategies, companies can protect their bottom lines, support sustainable practices, and enhance their overall competitiveness. As the energy landscape continues to evolve-driven by technological advancements, regulatory changes, and market dynamics-the need for proactive risk management will only grow. Companies that prioritize hedging will be better positioned to thrive amid uncertainty and capitalize on opportunities in the changing energy market.

Indian statutory bodies and regulators have also initiated many steps to encourage good risk management practices, especially commodity price risk. One such step has been SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, which require the listed companies to disclose the information related to commodity price risk in their Annual Reports, as one of the mandatory components of Corporate Governance Report (Schedule V, C(9) (n) and C (10) (g)).

Exposure of the listed entity to commodity and commodity risks faced throughout the year:

1. Total exposure of the listed entity to commodities in INR
2. Exposure of the listed entity to various commodities:

1. Commodity risks faced by the listed entity during the year and how they have been managed.

In our numerous discussions with different corporate risk managers on the derivatives trading desk, we have found that disciplined hedgers consistently outperform their competitors. This is true regardless of volatility levels and market conditions, as predictable cash flows are always essential. A comprehensive hedging policy should address all aspects of corporate operations. The key is to approach risk holistically, hedging as a package, and ensuring the policy is systematic and centralised.

Effective risk management in energy markets is not about avoiding risk; it\'s about understanding and managing it.