Hedging was supposed to be cool

Chapter 1: The workshop

After a year of being blasted by market moves, a director thought it was time to hedge and management agreed. A project team was formed and sent to a workshop where they learned about options and how to use them. They subscribed to research reports and started building a hedging strategy. They were confident that hedging would protect them from future losses.

Chapter 2: Early lessons

New connections in the market and the power of knowledge gained energized the team and implementation began. The first hedge went bad, the second one went well. They decided they should do more next time, and so they did. Market had fallen back to where the good trade was executed, so they doubled down. A good average had been established for the annual cost of energy. Then came the mark to market and time to report to management. There was a problem, the hedge was underwater. But the policy said hedge 80% and they were 65% with 15% more to go in the next 8 months.

Chapter 3: Mixed signals

The most senior team members of the team lost interest and the new hire was left with the responsibility to watch the market constantly and report if opportunities arose. Market fell further and they added 5%. At this point, another director said they were leaving money on the table and pressured management to look for opportunities to get out of the hedge. According to what he had been reading, the oil market was going to keep falling.

Chapter 4: The workaround

A relief rally came, the hedge that had been 12% underwater was now losing 5%. Their broker suggested they could "blend and extend", which meant to sell put options against the next year's accounting period and use the proceeds to fund a partial unwind of this year's hedge. Hedging was cool again. They were able to lower current year's hedge to 50% at the expense of selling puts for 25% of next year's hedge. This established a floor for next year at a level that looked good compared to the previous year's prices, and relieved the pressure in the current year.

Chapter 5: The call

The year was almost over, which meant budget time. As energy price was being discussed, treasury reported an email from the broker asking for a "margin call". This meant the company needed to deposit cash as collateral to keep the hedge alive. Otherwise, the broker would have to close out the hedge at a loss for the company that would have to be fully reflected in the current year's financial statements.

Chapter 6: Moving on

The deposit was made, the hedge had been fixing at a loss every month, the next year's price was already below the put strike. I believe the company decided to tackle future price volatility through contract renegotiations and operational efficiencies. Some thought hedging was dangerous and that only the brokers made money, so they abandoned the practice and focused on other areas of the business.

Chapter 7: The aftermath

Some companies abandon hedging entirely after experiencing a year of losses and missed opportunities. Others take it as a learning experience and try to implement systematic approaches. The transition is not clean, as systematic approaches require a level of detachment that is hard to achieve after strong emotional experiences. See our article about hedging is cool for more details about an ideal scenario where hedging works the way it is supposed to.