Price Management vs Risk Management

Market risk management for producers lives with an existential problem: the need to lower uncertainty while achieving a price objective. These two competing forces can result in increases in risk, a type of risk few dare to address: idiosyncratic risk --the risk of making the wrong decisions.

Seller Beware!

Price management introduces risk, we'll explore why through a series of bullet points:

• Wrong Instrument at the Wrong Time: Market is trading just under your price objective. Pressure has been mounting to take action, so you decide to sell some options in order to achieve the price objective, only to sell just before a volatility spike. Volatility spikes occur when market character changes. Tired of the previous regime, market pushes through to a new regime of higher prices and higher volatility. Both, the sold futures and sold options are out of the money. Technical analysis had been showing signs of oversold conditions followed by consolidation. Had this happened far from the price objective, you probably would not have sold. Proximity to the price objective was the trigger, not the market conditions.

• Market Seasonality: Commodity markets are seasonal, at least when it comes to volatility. As production or consumption shifts globally in a predictive pattern, volatility follows. Market price is slightly above the price objective, a decsion is made to set a stop loss. Market trades through the stop level and you are forced to sell. A few weeks later, a seasonal low occurs and prices normalize at previous range. The stop loss hedge is not under water for the remainder of its life. Years in the business have trained you to recognize these patterns, but the proximity to the price objective prompted a reactive decision.

• Trending Markets: Prices were bad in the previous two years, causing some supply disruption. Fundamentals point to a recovery in price given low inventory levels. Producer has set a price objective that is higher to current price, and there is a plan to accelerate hedges at or above the price objective. Market begins to trend higher, crosses the price objective, and a substantial percentage of the volume is hedged within a week. Market was breaking out and momentum was being established. Next month, a decision is made to average up, and another substantial percentage of the volume is hedged. Only two thirds of the accounting year have elapsed and producer is overhedged on a rising market. This is a hard problem to fix, and it was triggered by the existence of a price objective, not an incorrect view of the market's next move.

Achieved Price

It is better to have a benchmark than a set price. The bechmark can be a moving average for a period that makes sense, according to the seasonality of the business. The benchmark will move with the market and shift focus to execution and performance as opposed to hitting a specific target.

The performance can be measured with volatility bands around the benchmark, knowing that in uptrends, you will likely be below the benchmark, and in downtrends, you will likely be above the benchmark. The key is to stay within the bands and execute the plan.

It is better to live and die thinking that you will never achieve a price objective, but that you can achieve a performance objective.