High cost, lower risk.

Senior managers are using derivatives to guard against fluctuations in energy prices. But such instruments can also enhance a competitive position, project revenues, or bolster planning abilities.

Risk management is a critical element of corporate success. But risk can arise from unexpected sources. During the 1970s, when currency exchange rates were freed to float against one another, companies with sales abroad had to worry about shifts in the currency market. In the 1980s, managers confronted a new headache: unprecedented interest-rate volatility. By the early part of the decade, the cost of short-term money soared to more than 20 percent. Today, such rates are in the low single digits.

In seeking to minimize risk, many managers applied a new generation of financial instruments, known as derivatives. Today, such instruments are being brought to bear on another risk factor: the cost of energy. An increasing number of companies are using them to gain price protection and as a tool to achieve strategic. objectives. Custom-tailored hedging programs can enhance a competitive position, contain costs at a specified level or within a predetermined range, protect revenues, establish cash flows, or improve a company's planning abilities.

UNPREDICTABLE FACTORS

Apart from money itself, energy is the most pervasive of all economic inputs. But for a long time, energy costs could be ignored by those not directly involved in energy production and distribution because they remained stable. But price stability came to an abrupt end with the Mideast oil embargo in 1973, when the oil producing countries wrested control of supply and price from the big international oil companies. At that time, oil became a commodity.

Today, many other unpredictable factors influence energy prices. During the past two years, for example, we have seen a procession of events that have rocked petroleum markets. These include Iraq's invasion of Kuwait--and a subsequent war in the world's largest oil producing region, which ended with the oil fields of an entire OPEC country being set on fire--a coup and its reversal in the former Soviet Union, the world's biggest oil producer, and an oil spill in Alaska that threatened to shut in that state's production.

But in addition to this random volatility, energy prices also continue to be influenced by systematic factors, including steeply increased demand from newly industrialized countries, development of alternative sources of energy, usage taxes, the discovery of new fields, and effects related to climatic changes.

The outlook for the energy market is best described by Philip K. Verleger, a senior consultant at Charles River Associates and a visiting fellow at the Institute for International Economics. Verleger says, "We had better be prepared--if energy is important to us--to tolerate even greater price volatility." The consultant cites three structural causes for this trend, including changes in environmental regulations, new laws regarding the storage of petrochemicals, and the $100 billion to $200 billion that refiners will have to spend in the coming decade in order to upgrade their refineries to meet new standards for reformulated fuels.

Many corporations with significant energy exposure have declined to tap the derivatives market. In the case of utility or transportation companies, officers may be operating under the notion that risk management simply entails keeping a careful eye on consumption levels, or pushing suppliers for the best possible prices. At other companies--at which fuel consumption plays perhaps a secondary role in processing or product distribution--there is a good chance that management has little motivation to assess its vulnerability to price movements. Companies that have been restructured, merged or acquired are even less likely to have an a accurate picture of their exposure.

But energy risk management can also be important to such corporations. For example, whereas rocketing fuel prices might put a commercial airline out of business, they also may quietly erase the year's profits of a business that traditionally operates on thin margins and has a clear but more subtle exposure to energy costs. At a grocery chain, rising energy costs may sidetrack a company's cost-containment plan, weaken its competitiveness, or destabilize a restructuring strategy by interfering with its ability to service debt.

Moreover, beyond its direct influence, energy-price volatility may negatively impact a company's customers. Referred to as "revenue risk," a well-known example is what happened to makers of full size automobiles in the U.S.--and to their suppliers--when gasoline prices more than quadrupled in the 1970s. New car sales fell as consumers reacted to the increased cost of ownership.

STRATEGIC PLANNING 

In seeking to develop an energy risk-management program, corporations must first conduct a companywide audit of energy use. This must examine all aspects of energy production and distribution. Following the audit, a company must ask itself: Does energy hedging make sense? If the potential energy liability is sufficient, decision makers may decide to incorporate hedging programs into strategic planning. There are variations and hybrids of derivatives that can be structured to fit any time horizon, type of fuel, delivery location or quantity. In fact, flexibility is the hallmark of derivatives. Such instruments include:

Swaps. Fix a specific price on a commodity for a predetermined period of time.

Caps. Set a ceiling on the price.

Collars. Establish a top-and-bottom range within which the price of the commodity may vary.

One example of how a company might use energy derivatives involved a hypothetical glass manufacturer that burns one million barrels of residual fuel each year in its mills. Under this scenario, the price of oil has risen, and weak demand in a recession has made it difficult for the company to pass the increased costs along to its customers. As a result, profits are eroding. Seeking protection against price increases, the company enters into a swap agreement with a risk underwriter covering 50 percent of its residual fuel oil needs for the next three years.

The swap agreement establishes a price of $13 per barrel for 1.5 million barrels of residual fuel oil deliverd at New York Harbor. During the three-year period, the glass manufacturer continues to buy its fuel oil through normal channels, paying spot market prices. Every six months, a settlement takes place with the risk underwriter. If market prices--based on an agreed-upon index--average more than $13 per barrel, the company is reimbursed for the difference. Combining the spot-related price for physical supply with the swap payment recieved or made, results in a net fuel cost to glass manufacturer of $13 per barrel.

There are no fees or up-front costs associated with swap transactions. But in return for price protection, the glass manufacterer forfeits the benefit of any price declines. Had this company chosen a cap rather than a swap, it would have retained the ability to benefit from a fall in fuel oil prices, but would have paid an up-front premium for that right. If it had used a collar, the glass manufacturer would have avoided the premium and enjoyed some limited benefits from falling prices.

SETTING A STRATEGY

Corporate objectives are paramount in selecting the most appropriate hedging instrument. A swap can stabilize costs at a comfortable level, but may not be appropriate for a firm operating in a highly competitive marketplace. A cap can provide vital insurance against damaging cost increases, but may represent a needless expense if energy exposure is relatively modest. A collar may be the best alternative when both protection against catastrophic price increases and the need to remain highly competitive are equally pressing, but the operating budget is inflexible.

Market circumstances can also influence a company's selection. For example, because the up-front premium on caps is largely a function of market volatility, some companies may seek to apply a cap when the market is relatively quiet. On the other hand, if a commodity price is especially depressed, a company may decide the time is right to apply a swap.

Also consider the risks faced by a hypothetical mining company, which like its competitors consumes significant quantities of No. 6 fuel oil for one processing. In the current, stagnant economic environment mining companies' profit margins tend to be squeezed between high production costs and and the low prices for the physical commodities they produce.

SWAP ALTERNATIVES

In this scenario, a mining company wishes o ease a profit squeeze by fixing the prices of its fuel oil at a level lower than the $12.50 per barrel price at which a swap could be arranged at the time. To accomplish this, the company arranges for a one-year "swaption." Under the transaction, which covers one million barrels, the company is given a swap price of $11.75 on the first 500,000 barrels, which represents a discount of 75 cents per barrel from the existing market swap rate. In return, the mining company grants an option to the swap counterparty to subsequently increase the volume of the swap by another 500,000 barrels.

The ourcome? The mining company lowers and stabilizes its fuel costs on a substantial quantity of oil. If prices dip during the contract period, the counterparty would likely exercise its option on the second 500,000 barrels. On the other side, the mining company would continue to benefit from stable energy prices. But in exchange, it would not benefit directly from any price declines.

In sum: Using derivatives to limit exposure to price swings isn't without risk. Even a seemingly favorable hedging transaction can entail the forfeit of potential benefits if the market defies expectations.

But therein lies the fundamental motivation for energy risk management. Oftentimes, the market does defy expectations, more so now than ever before. Nonetheless, companies that correctly read market changes and use derivatives as a hedging mechanism will find themselves better positioned to weather any volatility.