Reprinted with permission from the Association for Financial Professionals.
By: Timothy Johanson
A strategy to better manage energy price risk can help you protect your margins, manage budgets more effectively, minimize overall cash flow volatility and be more competitive in rising commodity price environments. Businesses with a long-term view on enterprise value want to manage these risks.
Let’s take a closer look at the reasons for implementing an energy price risk management strategy and how it can benefit your business.
Frequently, the No. 1 concern among risk managers is protecting margins. Effective energy price risk management can help shield profit margins from adverse market moves, which may be driven by factors well outside your control (weather, for example). Imagine signing a long-term sales agreement for a product with substantial margin that is put in jeopardy due to a hurricane or some other unforeseen event.
An energy price risk management strategy can also help you achieve your pricing goals through a more predictable and profitable approach. Risk managers who work in more established industries like food production are more sensitive to fluctuations in energy costs. They need to make sure they meet expectations when it comes to sales. For instance, if one of your organization’s significant energy costs is diesel fuel needed to ship product across the country. You want to protect margins, but you also want certainty with a strategy that will allow you to manage to a certain budget level over time. So, you agree to a budgeted number for that diesel fuel (let’s say it’s $3.20 per gallon) for the year. By setting and agreeing to that price, you’re now managing to a consistent budget and giving yourself a better chance to meet corporate expectations when it comes to quarterly and annual revenue and profits.
One of the chief concerns of any risk manager is managing volatility. Mitigating price swings to pave the way for a smoother path forward should be one of the key goals of any price risk management strategy. Let’s use the previous example. You need to set a price for diesel fuel, and you’re going to buy within a certain range. Ideally, you want to take the volatility out of the equation by eliminating the possibility of buying diesel fuel for more than, say, $3.50 a gallon and less than, let’s say, $2.90 per gallon. Now, you know with absolute certainty, that you’re going to pay between $2.90 and $3.50 a gallon for diesel fuel in the coming year. As a result, you’ve just reduced the number of outcomes you might face versus if you just took the straight market price.
Every business wants to remain competitive—when costs are low and high. A good energy price risk management strategy should help you price your energy costs near or around the market average to keep you competitive. The key is to keep pricing at a competitive level when energy costs rise—this allows you to better versus those who might not be hedging their energy costs. Let’s go back to our diesel fuel example one more time. In the last six months, the price of diesel has increased 40 percent. Companies that haven’t been hedging diesel fuel costs are going to pay 40 percent more when they go to market versus companies that are hedging and maintaining those more profitable margins. That’s how managing energy price risk can help you stay competitive.
Enhancing Enterprise Value
One more reason a strategy like this makes sense—and it’s a reason that flies beneath the radar a bit—it can enhance enterprise value. Managing price risk through hedging diversification can result in a more stable cash flow versus having volatile P&L swings, help you minimize volatility to organizational value and better manage to budgets. For example, if your business is even considering selling two to three years from now, price risk management can help you develop a more stable earnings stream, which can help you determine a value price from a stock perspective.