The Business of Hedging

!Many industries are both blessed and cursed with having one or two major costs functions beyond management control in the commodity category i.e. agricultural products, energy (crude oil, natural gas), fuel, interest rates etc. Over the years many a company has died a thousand deaths at the mercy of depressed prices or out of control costs. During these extreme periods no amount of cost containment, vendor(s) negotiation or overhead reduction solves these problems. These price/cost anomalies are just too big and too fundamental as a percent of total income/expenses. They cannot be managed away in the normal course of business. If not properly controlled, these kinds of price/cost distortions can easily determine corporate destiny.

Fortunately, many of these income/expense items are traded on US commodity exchanges and many times can be managed through proper strategic hedging. Unfortunately, many companies, CEOs, CFOs, and Boards of Directors etc. have had bad experiences with hedging or in reality, know little about hedges and how to properly implement them. Many times, out of fear or ignorance, these decision makers quickly dismiss the concept. Most individuals confuse hedging with speculating. Many individuals believe hedging is simply buying at a low price or selling at a high price. This is not the case. Hedging is only about reducing risks and managing corporate earnings.

Hedging is a technique of using futures contracts and/or combinations of futures and options on the publicly traded commodity exchanges to REDUCE RISK. The other side of hedging is speculating; where other parties willingly take the opposite side of the hedging trade; in the hope of making a profit. The commodity exchanges were specifically created and designed to allow buyers or sellers of goods a way of pre-buying or pre-selling their goods at a known price with less risk. This price is normally never the best price, high or low; but a known price. Ironically as a user, if you do not hedge you are in essence; the speculator.

All commodities i.e. crude oil, natural gas, corn, soybeans, fuel and interest rates go up and down in price based on a wide variety of variables too numerous to count. These prices sometimes seem to operate rationally in accordance with the perceived laws of supply and demand. Other times they seem to move totally irrationally due to a myriad of forces including and especially today; government actions.

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A properly designed hedge does not attempt to pick the absolute high or bottom of a price movement. A properly designed hedged position is based on an analysis of historical results of a price, in consideration for the impact on earnings, over a long period of time. Based on this analysis, reasonable probabilities can be discerned regarding the general likelihood of the success of the hedge. An informed management decision can then be made regarding the total costs and the associated impact on corporate earnings. If locking in those prices for future periods generates favorable earnings relative to historical performance, the implication for management should be, to reduce risk and secure these profits. Then, based on this new price assuredness, other operational decisions can be made accordingly. Proper hedging can create many positive opportunities, i.e. stable customer pricing, stronger balance sheets, more aggressive growth or new M & A activities.

The hedges themselves may make or lose money. The hedge profit or loss is not important if, the net prices obtained, fit the original guidelines and achieve management goals for stable or improved earnings. These goals should measure return on invested capital, return on equity, earnings per share etc. Handwringing or second guessing about higher prices or lower costs of the hedged commodity should be of no concern, if the real corporate metrics are being achieved. Hedging is a risk mitigation and corporate profit planning tool.

From time to time there are opportunities to take advantage of extreme commodity price anomalies. When these anomalies occur, properly designed hedges can keep companies out of bankruptcy and/or make them enormous amounts of money at the expense of their un-hedged competition. The crude oil/fuel spikes of a few years ago and the current super low interest rates today are very good examples.

! Price Risk Management, LLC !

Albert C. Randolph Dennis Mangan (202)-667-6700 (303)-713-9694

Albert@pricerisk.management Dennis@pricerisk.management

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