Hedging may be downside to commodities' price drop

Monday, August 25, 2008

NEW YORK — Commodities prices have eased in recent weeks, but for some companies the record gains are far from forgotten.

Whether it's temporary or not, the reversal should provide a reprieve to strained profits at companies with heavy exposure to commodities like energy or food.

But there's an unintended consequence for those who bet prices would keep rising, and locked in what they thought were good deals. Their previous price contracts could mean they have to pay more than the current market commands.

That financial strategy, known as hedging, is akin to an insurance policy that companies use to protect themselves from the possibility of higher market prices. By hedging, they can lock in prices for future output or raw material costs, a seemingly smart move if there are expectations that prices will continue to climb — which has been largely the case for the last two years.

But hedging can also backfire if there is a sharp decline in prices, which is what happened from mid-July until this week as the dollar gained strength and there has been increasing evidence of global economic weakness.

The price of crude oil doubled since last summer to hit a trading record of $147 a barrel July 11, amid expectations of surging global demand. That led some to believe it could keep heading higher — maybe even to $200 a barrel.

Now, it stands around $121 a barrel, up from a recent low of about $112 a barrel. Such recent price swings illustrate just how difficult it can be for companies to hedge.

Volatile commodities

In other commodities markets, there also is notable volatility. Corn prices have fallen almost $2 — or about 24 percent — since closing at an all-time high of $7.805 a bushel July 2. Corn fell to a five-month low of $5.17 a bushel Aug. 11 but has rallied over the past two weeks, climbing 16 percent.

To see how all this could affect corporate profits, look at Continental Airlines Inc., which like many air carriers has used hedging to try to reduce its fuel costs.

For the third quarter, it has hedged 63 percent of its projected consolidated fuel requirements. Nearly all of those positions include something known as a collar, whereby a maximum and minimum price level are set.

What's important to watch is how the prices it locked in compare with the spot price for crude. For instance, Continental has about 33 percent of its crude oil hedge positions capped at $140.81 a barrel of oil, good news had prices continued to rise. But the average floor is $120.90 a barrel, right in line with current market prices, according to securities filings.

For the fourth quarter, 65 percent of its projected fuel requirements are expected to be hedged. Some of those positions have a minimum crude oil price of $126.25 per barrel and minimum heating oil cost of $3.63 a gallon — both above current market prices.

Continental spokesman Dave Messing said the Houston-based carrier is adjusting its hedging on an ongoing basis and there is no telling where market prices might be when the third quarter ends Sept. 30. But he notes that in situations where the positions may be "out of the money," it is "extremely important not to overlook the insurance value that the position provides," he said.

"The purpose of our hedging is not to try to win a Las Vegas-style bet; it is to reduce risk associated with fuel price volatility by buying a form of insurance against a potentially harmful price increase," Messing said.

This isn't just an issue for airlines. Hedging has been used by a wide range of companies with a reliance on commodities, whether they make cereal or alternative energy.

VeraSun Energy Corp. has seen significant benefits from hedging the price of corn, which is used in its production of ethanol. Its hedge positions boosted its second-quarter earnings by $25.6 million, or 10 cents a share — resulting in a better-than-expected quarter.

But Citigroup analyst David Driscoll warns in a note to clients that the Brookings, S.D.-based company's third-quarter results face "significant headwinds" because corn prices have declined significantly in the last two months.

He anticipates that will result in a "full reversal" of the benefits from hedging the company had in the previous quarter. The company declined to comment on his note.

Clearly for some, declining prices are a double-edged sword. As much as they were wanted, they might not always help.

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