Episode 2 – Hedging vs Speculation
“I mean, let’s just be honest, trading’s a lot more fun to talk about. Right?So getting them into the right frame of mind is the first step.
We’re here to be boring. It’s just not as much fun to be an insurance guy as it is to be a trader.”
In episode 2 of The Hedge, we discuss a common topic in risk management circles – hedging vs. speculation.
Topics:
- Hedging 101 – What is the difference between hedging and speculation or trading?
- Southwest Airlines Hedging Success
- Where customers make mistakes – over complication vs lack of sophistication.
- Year two – where you really see the benefits
Steve will get into some common conversations he has from the boardroom right down to the execution desk.
Your Hosts
The Hedge is a collaboration between EKT Interactive and Blue Lacy Advisors, an energy risk management consultancy.
Blue Lacy Advisors is headed by Steve Sinos, a professional with 20 years experience in energy markets.
Our goal here at EKT Interactive is to bring expert voices and insight to our learning community, so in this effort, Doug Stetzer, VP of Content and Community and EKT Interactive Energy Training will co-host this podcast with Steve.
Links and Resources
Blue Lacy LLC – Strategy and Risk Advisory
Transcription
Hey everyone, Doug Stetzer here, and we are back with episode two of The Hedge, brought to you by EKT Interactive and Blue Lacey Advisors and Energy Risk Management consultancy.
In this episode, we’ll talk about an important distinction in risk management, of hedging vs speculation or trading.
These activities have different objectives, and yet, as Steve points out, the first thing he often has to do is move the conversation with his clients beyond where do you think prices are heading?
We talk about some examples of successful hedging programs, as well as how Steve is encouraged by the level of financial sophistication that he sees and new hires and the analytical teams that he is working with.
I really enjoyed this talk, and I definitely think our learning community, but really anyone in risk management will get some good information out of it.
Hedging vs speculation or trading, right? And again, diving into this idea of not being a market predictor, that is not the goal, right? We’re an educational platform.
Uh, we have energy 101. Let’s talk with a little hedging 101.
Hedging 101 – Hedging vs Speculation
You know, from your perspective, if you’re talking to somebody who’s really looking to just get started, you know, what is the framework or, or what do you try to make clear, like right off the bat when you’re talking about a hedging strategy?
So if we, to contrasting what we last spoke – hedging vs speculation.
Even the best books talk about, about finding edge and executing.
And even the words they use when they say hedging no longer apply to our assumption, right?
You’re not trying to make money with a hedge. The best example in the textbooks that they use is when you start thinking about options in the form of insurance, right?
And they compare things like homeowners insurance or health insurance or any sort of traditional form of insurance, that’s easy for the layman to sort of wrap their heads around where this is a cost embedded in life to avoid something unpredictable.
“You’re not trying to make money, you’re trying to minimize pain.”
You’re not trying to make money, you’re trying to minimize pain that is maybe predictable if you had infinite time, but the timing of it’s arrival is unpredictable, right?
So you’re choosing risks intentionally because you’re trying to reduce the unknown timing magnitude, whatever it is, right?
There’s some form of pain that you’re trying to eliminate. And through that you can have a cost benefit analysis of if is it worth it to use this hedge for this period or this product?
And over time that should net reduced costs or improve profitability depending on which angle. Whether you’re a, you know, a commodity seller or a commodity buyer, and you’re getting, you’re not getting paid to be good at the market.
You’re getting paid to be good executing your strategy, and this is that portion of that payment that you’re willing to use to make sure that you are gonna continue and get paid to execute strategy.
It’s a completely reframing of everything in the textbooks.
You aren’t going to be able to algorithmically calculate your way to where you have a free insurance product that pays you when you’re right and doesn’t cost you anything when you’re wrong.
So you have to think about it in the same way you would think about actually procuring the commodity, right? Or the services to produce that commodity.
Does this make business sense to do, does this improve my strategic position?
A series of binary questions like that to ultimately decide what, what your net hedge portfolio looks like. And that’s probably too high level or too generic, but until you can accept that as, as your starting point, you gonna lose, right?
Cause the conversation will inevitably get back to what do you think the prices are gonna do? Is this a good price to hedge at things like that? Which you, the answer is unknowable to them.
Southwest Airlines Hedging Success
And, and you see this all the time, right? Like even in the financial press, we kind of connected about this a little while back, You know, there’s a big story, you know, the Southwest Airlines hedging group made a ton of money. Well, is their job to make a bunch of money?
Is there job to keep the company from going out of business by having costs spiral outta control and past, you know, through their profit market, right?
Like, oh, yeah. Like, just the framing of that, that headline even just goes to show that we love it when trading groups make money, but is it even really their job, Right?
Like is in this particular sense, is a, you know, the hedging strategy, it’s an, it’s an insurance product, right? It’s not Yeah. Necessarily a money maker.
Well, and in that article, the Southwest guys, they talked about how they evolved over time, right? Like, so Southwest is popularly covered because they were one of the first airlines to publicly discuss their hedging practices.
And in the nineties, right? Remember oil went from, you know, basically zero then to 50 bucks, which seemed like a high price then coming out of the decade, right?
Southwest made headlines for being one of the few domestic airlines that had benefited from a hedging program, and they were comparatively aggressive to what they are today after having sustained billions of dollars of losses in certain years,
And making headlines for that, Right? And now their traders are quoted as being like, If you think you can do this better, good luck to you.
This is hard. We’re just basically buying insurance.
And they use the, they reference the specific products they used where they’re buying calls and call spreads and things that have a defined cost, right?
For a potential gain. And I think that gets back to what you’re saying, right? Like, they’re not passed with making money in a year where the, where they make money when prices fell, they’re probably looking back and like, well, we did this wrong.
I’m sure they would like that as far as the bottom line goes, but they, you know, they’re not, that’s not how they’re probably judged on success and from a, you know, starting from scratch, somebody who’s learning about hedging. That’s, that’s really where step two is then, right?
So if you accept that your goal is something other than making money, you have to define the goal. Mm-hmm. <affirmative>, what does it mean to minimize volatility, maximize profitability, whatever these kind of generic terms are that any business student can rattle off. Like you have to actually put some numbers around this so you can judge your success, right?
And we, we talked about profit margins, you know, groups like CX and FedEx, they’re very narrow, right? Roughly four or 5%. The volatility around those tends to be two to 8%. Sometimes they go to losses, right? And so they b those types of company manage this risk in very different ways.
Um, I don’t know FedEx for sure. Um, as far, I don’t know if they actually have any true hedges on, but I know that many transport companies like FedEx and trucking companies in particular simply just pass those costs on through fuel surcharges.
They say, This is a risk of doing business that I don’t want, so I’m gonna charge you for it. Right? It’s not perfect. Sometimes they actually lose money on it, but less often than they would if they were just purely buying or selling a fixed price product based on their opinion of the market, right?
So they’ve tilted that decision in their favor by pushing it off the cost of it off onto somebody else, right? Whereas somebody like cex, which is a large global consumer of a variety of different products, has to think more deeply about which of those are embedded in their net output, right?
Which of them are commodities that they are willing to wear the risk for, and which are those that they don’t understand well enough to where they want to eliminate the risk for, and then the spectrum between the two, right?
And so, and that’s for groups whose profit margins only vary in percentage terms, they’re 25 or 50% variants, but in actual terms, you’re talking about somewhere between two and half to 6% up versus a low versus a high, right?
Whereas a group that, you know, the, the pre pandemic, right? Shale producer profit margins might go negative 50%, one quarter positive, 50% the next quarter.
Who knows? And they’ve layered, you know, back then they had 30 turns of debt on top of that, right? Right. Now they that to a more manageable level. And so you’d have, they would by nature have to be more conservative if they were going to hedge in the cost that they could, you know, that they could commit to it.
And so we can’t guess what success would look like for any individual company, but you can see what it would mean to minimize volatility in those scenarios and then get to that coming, Okay, well, hedges should minimize volatility by X within a cost of Y, right? And if we do that, that’s first order success.
And then efficiency beneath that could be the second and third order of success, you know, of execution. So it’s,
Let’s, like one of the things like, you know, you kind of mentioned there like, you know, was with this Southwest example, is that it sounds like, you know, just at a high level is that they don’t overcomplicate things.
Where do people overcomplicate things when it comes to hedging strategies?
They just do they get enamored with buzzwords – hedging vs speculation vs trading, zero cost collars – and products when they should just be buying calls or buying puts?
Uh, sometimes, but I think it’s more in the minutia of hedging in the, versus the grand scheme, right? So if you think about just buying calls or just buying puts, and you look at say, an at the money put today might cost, I don’t know what, it’s off the, let’s say it’s five, right?
On an, on an on a, on an oil price of roughly 80 bucks over the next, over the next 12 months. So you start thinking, Oh, wow, five bucks, that’s a lot of money. Times a thousand barrels for every contract I hedge that’s 5,000 bucks.
Do I have to write a check for, you know, 25,000 bucks if I on a hedge 5,000 barrel? And they get lost in, in that piece. And it’s, it’s kind of interesting to walk, because often these are guys who are, you know, their skills in math are well advanced, right?
You’re talking about CFO types chief accounting officers, guys who live in scenario planning worlds, and they get lost in that piece, right? Like, oh, that’s too expensive. And then the next thing they dive down, they’re like, Oh, well what if it was only $4 and 75 cents and they start negotiating on pennies and getting lost in the actual dollar value gained? That’s the hardest part.
Often that’s partially because they don’t have cash on hand and they’re unaware that they can defer these costs to the period in which the cash flow is tied, right? And so in recent years, one of the, the more common things to do would be to defer premium.
There’s a cost to it, but it’s modest or to create structures where there’s little cash up front, but are still net long or net short appropriate to what, what your hedging should be.
Zero Cost Collars
In past years, people were rather enamored with things like zero cost collars, or costless collars, because there was no upfront cost, right?
Right. But mathematically, those have the same risk with zero cost collars as a pure swap and typically out, you know, given, you know, you’re, you’re using out the money options will have less of a payout, right?
And so you have to be very careful about balancing the difference between zero cost upfront, right?
Zero premium and the actual net benefit of a zero cost collar. And so they get lost in the weeds on immediate costs and then they miss the details on things like that and sometimes make bad decisions as a result.
But, um, in the last, in recent years, both market makers and clients I think have come a long way from, you know, getting lost in the trade execution into really thinking broadly about how does this fit the strategy?
And it, you might even argue sometimes overpay for options because it’s a better fit culturally for what they’re trying to accomplish.
This is more common in airlines who hedging losses tend to occur when they also have volume reduction. So not only are they losing money on their hedges, they’re making less money than they anticipated because there’s a downturn in the, in a, in an exaggerated example would be during the pandemic where we grounded airlines, right?
You know, they went from somewhere in the range of 90 to 110% capacity all the time to flying 5% capacity. And you know, Southwest we mentioned, but really all the airlines that had fixed price hedges were so far underwater that they were being bailed out, you know, through different credit facilities, not the least of which where government bailouts and things like this mm-hmm. <affirmative>.
And they looked back and they said, Wow, that was a bad decision made for the wrong reasons. Now we’re long options that give us the flexibility.
Even if a true options trader would look at our portfolio and say, Wow, you overpaid for these options or zero cost collars, they would say, Yeah, but we paid less than we would if we, you know, if this happens and that’s our real risk.
We’ve got dumbbell risk and so we’re buying insurance against those dumbbells.
It’s year two when we really get to see the best value.
That’s when you start to really kind of have that, that moment of excitement as a consultant where you see a client pushing back on different things than hedging vs speculation and say like, actually like in the past we did it this way and this is the pain I felt, even though on in my spreadsheet this makes sense.
I know my boss is going to hit me over the head.
If this thing happens, what is, what is the probability of that scenario happening and what do we need to do to prevent the, you know, the second order pain, Right?
The hedge from being the problem.
And so that’s, I think that’s been a really interesting transition. Um, in the same vein, I’ve seen small EMP companies go from being, we’re just gonna do some zero cost collars and walk away from it.
We’re gonna do it at a rolling six month period because our lender obligates us to be hedged relative to our credit facility and gives us no credit for any hedges beyond that six month redetermination period to asking the question, What is the portfolio of hedges I should consider to have this net risk?
And it’s been really cool to see the younger generation, the finance guys come up in the small e np world, small private EMP world and have, and start at a level of expectation and sophistication and hedging that is probably a MBA level, right?
Instead of in the past you were starting from scratch. And so you’ve really seen better questions being asked and more appropriate approaches where they’ll, they’ll still do costless callers because it is, it is a good product when used appropriately, but they’ll layer in some fixed price and maybe some deeper out of the money, you know, um, offsetting calls or something to just in case things go wrong.
And they’ll have a budget to do that and they’ll rethink it regularly. Typically for e p right, you’ll typically rethink it monthly.
And then when you have a new drilling plan change, or somebody like an airline or a large consumer, you’re probably looking at it somewhere between weekly and monthly and then quarterly, cuz you do quarterly planning, but weekly, cuz you, procurement is typically based on a weekly price mm-hmm. <affirmative> and measuring variants within that and then optimizing your portfolio as appropriate.
So probably a little bit longer answer than you expected, but those are the trends I’ve seen in the last three years and it’s been really encouraging because it was really hard to be a consultant that had to start from scratch every single time.
And then it was never, okay, we’re gonna start from scratch together and go to step two and then three and then four. I was always like, we’re gonna keep touching base with scratch just because you’re not comfortable that this is different than what your textbook said it was gonna be. And so that’s been a, it’s been a really enjoyable few years to see that expansion.
And I think we’ve developed some really good relationships with clients as a result because you take into account the internal kind of political risk, right?
Like, what am I trying to accomplish as a person to get promoted or to get my bonus or whatever it is, and how can I share that story with, you know, whoever it is I’m answering to, to make sure that we’re on the same page about what we’re doing.
So when inevitably you’re going to have losses in your hedging portfolio, when we have these losses, we can explain them and we can defend our decision. Best case scenario, you can minimize them or even avoid them.
But sometimes it’s, it’s just not gonna happen, right? Like sometimes you put yourself in a position based on what you know today and then tomorrow everything changes and you have to adjust.
And so it’s been, it is been a really enjoyable first year for Blue Lacey and several couple of years as an independent.
Yeah. And there, there’s a, like, so there’s a couple of things in there like, you know, first like, you know, maybe I even phrased the question wrong where I was like, where do people over things and, and I think what you’ve kind of highlighted was that in one sense, you know, like, you know, you were mentioned in, in this is probably where our relationship even together like, like first started was back in the world, these just zero cost collars all the time.
Like that was oversimplifying and maybe not even recognize where the true costs of those zero cost collars lie and, um, who is benefiting from those. And um, they needed to up the degree of sophistication a bit and that you’re seeing that sophistication improve, which is rewarding.
So that’s like really interesting actually to hear.
And then I guess following up on that, you know, you, you’ve mentioned, you know, you’re, you’re dealing with everyone here from cfo, accounting officer level down to, you know, the actual execution team.
And, and even like you said, seeing younger people bring in a really, um, impressive degree of, of uh, understanding about these markets.
And so when you come in, like, like, like where are you, you know, kind of influencing this group, like kind of upstream towards the top of the, the pyramid and also kind of, I guess educating and, and and influencing, you know, like on the execution side and, and where new people are, um, and less experienced people are coming into an organization.
Like where do you feel you have a lot of influence there or, or, you know, does it depend on the client?
Does it depend on, you know, obviously like the company itself, what they’re looking to do, but you know, it seems like you’re reaching like from from the top all the way, you know, down to the middle of the organization there.
Is that correct?
Well, it depends on the size of the organization.
Like a, the larger the organization, the less likely, uh, you know, I would be to have direct, um, interaction with or communication with their senior leaders. And the smaller the organization, the more likely that the entire team is the five people that you talk to on a monthly or weekly basis, right? Right.
There’s a little bit of that. And so that it’s a, it, it’s a function of the fact that my clients range from uh, five person EMP company all the way up to one of the largest fuel traders in the world. You know what I mean?
Gotcha.
But in the, so I can describe the ideal case. Let’s say the typical client would be between those two extremes obviously, right?
And so in the annual life of a contract, you’ll have regular, probably weekly if or monthly at least contact with whoever that person is that is sort of feels that daily stress of commodity and volatility your most. And that’s
Feel stress. I like, I like that.
Yeah. So you you think sort of like, who’s the guy that when you know, the boss man sees that, you know, diesel prices are four or $5 on cnbc, like who gets that phone call? Right?
You know what I mean? Sometimes it’s the vice president of procurement, sometimes it’s the vice president of treasury, the sort of kernels of the organization, right?
Leadership got type guys, but not necessarily the top general or president that is making strategic decisions.
These guys are typically tasked with executing those decisions, maybe have some say in the direction of how that execution goes, but probably don’t have a whole lot of say in what the actual strategy is.
That’s the, those are the most common touch points over the life of the contract.
In the ideal world though, like you would work directly with that leadership level as well to sort of express how their strategy might be affected or change and give them the tools to tell that story.
Because no matter how senior you are, you’re answering to someone, even if you’re the chairman and ceo, you’re answering to investors or creditors or whatever it is, and you have to be able to tell that nuanced story or at least give them the tool to defer it to one of, you know, a junior person that can tell that story, right?
So that’s a less common conversation cuz those guys are busy with whatever it is they’re getting paid to do.
And it’s typically not managing commodity risk. So you figure the cfo, the vice president, treasury vice president, procurement types, you talk to them weekly or monthly and then their bosses come in once a quarter and you make sure that they’re not surprised by anything in the meantime. Right?
Now you don’t wanna neglect the junior guide, right? Because the, cause you know, stuff rolls downhill, right?
Right. And so often you’ll see a spreadsheet and you’re like, Well who made this? You’re like, oh, so and so analyst.
Like, okay, I’d like to talk to him. And they’re like,
Why? I was like, well, I wanna make sure that he understands everything he’s doing and is asking the right questions cuz he is going to be the first one to see something go wrong in this spreadsheet.
And if he doesn’t know to ask questions or even the questions to ask, like, everything we’re doing is more difficult, right?
And so you figure, I like to build in touch points for the most junior guys that are the spreadsheets, you know, analysts that are tasked with calculating these things even though they have no decision authority at any level, right?
You’re never gonna win a project by impressing those guys, but you can lose, you can lose a client by letting those guys down.
So you wanna be extra sensitive to the guys that are doing that work. And I’ll typically do at least an annual offer to do some kind of, you know, really informal webinar or discussion just like, Hey man, I’m available just in case we’re coming up on a big thing.
What do you wanna talk about? And for the larger clients, they’ll typically bake in an actual seminar where we go through and when they have an onboarding season, right?
Maybe it’s early summer for large entities in the US or, uh, you know, you know, kind of the, the investment banking cycle, right?
You’ve got early summer guys, you got, you got, uh, December graduates, that kind of thing where we’ll do, uh, an intentional contribution to their training.
And that’s, that seems to have gone over really well, even in some cases, um, spun it more as like a career development class where they’re, you know, sort of seeing how vendors interact with accounting myself as a vendor in that case with their senior, you know, leaders to see how their work actually gets built into these decision making processes.
So that’s the ideal. It doesn’t always work that way. That would be the ideal.
Often you end up having, you know, one really good contact that you email back and forth, you know, 2, 3, 4 times a week, and then once a month you’ve got your set call where all of the people I described join and, and you know, that’s just a function of how busy are they internally, what resources do they have?
And I have some clients and so just frankly don’t have extra hours in their day right. To, to just have a phone call. And so, we’ll, we have a built in, you know, monthly call that sometimes they’ll miss, but we’ll make sure to have a follow up.
You mean when, so you don’t get to talk to everybody, but in the ideal case, you touch those bases in, you know, kind of a bell curve, the VP level guys you see all the time and you see the junior guys and the senior guys regularly enough, you know, not quite as often as the execution guys, but regularly enough to where, you know, you can totally understand their expected reaction to things.
Well, and it seems like, you know, that’s just the nature of your service since, you know, as a, as a consultant, you’re, your touchpoint is influencing the strategy, but without solid execution of that strategy, like what’s the point? And so you wanna make sure you’re your touch, you know, you have some touchpoint there, but obviously like your main communication is with the, you know, the person who’s, who’s implementing this strategy kind of at a higher level, right?
Um, yeah. So, and and like you said, like that, that looks like a lot of different things for a five person group versus a, you know, a thousand person group.
So, uh, you know, that’s really interesting man. And uh, you know, again, getting back to this idea of like just the, the hedging versus the trading, really understanding what the goal is here is, is, is kind of the point, right?
And that’s probably the first, And, and at a high level, people, they do know the difference, but they, you know, they may kind of talk and act like, you know, in ways that are not consistent with that, right?
Um, and so getting everything moving in that right direction, and on that same page, it’s, I’m, I’m guessing like, you know, really the first step,
I mean, let’s just be honest, hedging vs speculation and trading? Trading’s a lot more fun to talk about.
Right?
Right, right. So, so getting them into the right frame of mind is the first step.
Yeah. We’re here to be born. Yeah.
It’s just not as much fun to be an insurance guy as it is to be a trader, you know what I mean? Like, it’s, it’s unfortunate in that we don’t put greater value on consistency and reliability and these sorts of things as we do disruption, you know what I mean?
Right. And, uh, but in reality, like, you know, so I, I’ll probably never be on CNBC bragging about my billion dollar call, Right.
But that’s okay because ultimately our goal is to ensure that we’re never on CNBC explaining away our billion dollar loss either.
Great. Look forward to it.
All right. Awesome.
Okay, well I hope you enjoyed that conversation on hedging vs speculation.
If at this point you’re already thinking, man, we need to get Steven here, then you can contact him@bluelaceyllc.com. And of course, if you’re interested in learning more about the EKT Interactive Energy training courses, then be sure to visit us@ektinteractive.com.
Thanks a lot, and we’ll talk to you soon.
