Cargill Risk Management gave an overview of the new era of price risk management in Mexico last December. In that article, we talked about the change that the market will emerge into a free-pricing environment in 2019. We also stated that importers, distributors and retailers could expect to bear risk in price fluctuations in their own books. In this article, we provide an overview of some of the industry’s immediate questions and follow up with examples of how a risk management strategy may help a company mitigate risk.
Moving to a free-pricing environment
With the change to a free-pricing environment, the industry wanted to learn if it should hedge and how that mechanism worked. Common questions included: What risk will I have? We haven’t seen a change like this in a very long time – how will this affect me? Why bother hedging? Hedging seems complicated. How would I even start? The first two questions are ones that risk managers need to consider for their specific businesses. We will unpack the other two questions below.
Why bother hedging?
Oil is one of the most liquid markets in the world, but it can have significant volatility. The basic principle of hedging is that it helps protect your margins. In short, it gives you more predictability and small movements in your margins – ultimately allowing you to focus on the rest of your business.
Hedging seems complicated. How would I even start?
Hedging doesn’t have to be complicated. The first step is understanding what risk is and what risk exposure can be hedged.
There are many sources of risk – you can see some of those here. Cargill Risk Management isn’t here to control the source of the risk, instead our role as an over-the-counter (OTC) provider is to help customers control what they can.
Risk exposure that can be hedged must be highly correlated to a transparent, tradeable and liquid index.
- A 100 percent correlation is ideal – and possible if the same index is referenced in all contracts – but more than 80 percent is preferred.
- It must be transparent, meaning that market prices are published at least daily by an independent entity.
- It needs to have the ability to be freely traded by on- or off-shore counterparties.
- It must have a minimum level of relative liquidity
The objective of hedging is to protect your margins from adverse movements in market price.
Let’s look at a couple of examples of how hedging might work (or may not be necessary) – note that these are Mexico-centric scenarios but can be used as thought starters for other areas.
Scenario 1 – Gasoline import to Monterrey by truck: one-day risk window – low exposure risk
A risk window of less than one day is very short, meaning that exposure is limited, so hedging may not be necessary. Considerations:
- If the Gulf Coast price reference (e.g., OPIS) for the purchase price in Brownsville is different than for the sales price in Monterrey, then hedge as follows:
- Day 1 (start): Sell a Bullet Swap when you Buy the Physical
- Day 2 (end): Buy the Bullet Swap when you Sell the Physical
- If the reference level for the purchase price and sales price is same, there is no risk exposure and therefore no need to hedge.
Scenario 2 – Diesel import to San Luis Potosi by rail: 25-day risk window – high risk exposure
The risk exposure window is 25 days, broken into five periods consisting of 21, 22, 23, 24 and 25 days respectively. Hedge:
- Day 1 (start): Sell a Calendar Average Swap when you buy the physical. Averaging period should be Day 21 through Day 25.
- Day 21 thru 25 (end): Each day 20 percent of the CalAvg Swap expires as the corresponding physical product is sold.
Scenario 3 – Gasoline import to Veracruz by ship: 13-day risk window – high risk exposure
Risk exposure window is 13 days, beginning when the purchase price is an average of three days around unloading, and ending when the sales price is established over a 10-day sales window. Hedge:
- Day 3 (start): Sell a CalAvg Swap for one third of the total volume. Averaging period D6 thru D15.
- Day 4 (start): Sell a CalAvg Swap for one third of the total volume. Averaging period D6 thru D15.
- Day 5 (start): Sell a CalAvg Swap for one third of the total volume. Averaging period D6 thru D15.
- Day 6 thru 15 (end): Each day 10 percent of each of the three CalAvg swaps expires as the corresponding physical product is sold.
Hedging doesn’t have to be difficult or costly, but it needs to be done right. Cargill Risk Management is here to help you find solutions that work for your OTC hedging needs.
Check out our recent infographic about why you should have an energy risk management strategy.