The book contains practical, straightforward guidance on managing financial risk associated with fluctuating commodity prices, foreign currency exchange rates, interest rates, and weather. It lays out clear illustrations of how futures, options, and swaps work to curb risk. These illustrations are downloadable with the audiobook edition.

The book first came out in e-book format in 2014 when it was entitled Hedging Commodity Price Risk. When the print edition was released in 2019, the title was changed to Hedging Demystified: How to Balance Risk and Protect Profit.

You can find the audiobook version at Amazon/Audible (affiliate link), Barnes & Noble, Kobo/Walmart, and Libro, among other places.

On July 1, 2019, Open Road Press will officially release in paperback Hedging Demystified: How to Balance Risk and Protect Profit. Written by experienced hedger, seasoned business professional, and award-winning author Tim Bishop, the book provides anyone who touches hedging in a business context with a basic understanding of the complex subject. It presents practical and straightforward examples of hedging and explains in plain English how it works.

Originally released in 2014 as an e-book called Hedging Commodity Price Risk: A Small Business Perspective, this primer on hedging has undergone a much-needed facelift. Tim Bishop talks about why:

The old title was not reader-friendly. Furthermore, it did a mediocre job of describing what the book contained and who it would benefit. The old title unnecessarily narrowed the target audience. Anyone anywhere who wants a better understanding of how futures, options, and swaps can manage financial risk will grasp the concept from this book. Business size is irrelevant as is the type of risk being hedged. Whether a business is hedging currency exchange, interest rates, weather, or more traditional commodities such as oil, corn, or coal, the hedging tools work in a similar fashion.

When I released this as an e-book, because of the cost of production and marketing I decided to table a print version and move on to other projects. My perception of the market size for the niche topic suggested it wasn’t worth a substantial investment. The ugly old red cover was a reflection of this stance.

That was before our transition to Small Press United in January 2019. As the small publishers’ arm of Independent Publishers Group, it offered us a cost-effective solution and ready access to important sales channels. I had already seen the book sell as an e-book, so a print-on-demand offering made sense.

Since I’ve begun marketing Hedging Demystified, however, some large organizations have expressed interest in using it to acquaint their constituents with the foundational principles of hedging. These organizations see the book’s potential as a marketing piece and a supplement to their own educational initiatives. Their clients often struggle to relate to them on the use of derivatives, which have tremendous potential to rescue business owners from economic catastrophe.

For more information about the upcoming release of Hedging Demystified, see this news release.

Someone stopped by my Fiverr hedging gig the other day shopping for a Bitcoin hedging solution. He described himself as a digital currency dealer. After I explained that my exposure to digital currency (or so-called cryptocurrency) was slim to none, I agreed to investigate further to see if I could help him. After all, traditional hedging concepts should apply regardless the currency.

I embarked on a crash course on crtypocurrency. Bitcoin and its cousin rivals such as Ethereum and Litecoin represent a growing trend to implement currencies that work well with today’s digital commerce. These digital currencies seek to avoid government interference, precious metal backing, and other traditional currency entanglements. After my jet-ski tour of the subject, I traded thoughts with my potential client. We concluded that the markets and the currencies were not mature enough to allow for a hopeful hedge.

Our “cryptocurrency waltz” was a reminder of some significant considerations when hedging any type of commodity price risk. While bitcoin may have received some bad press due to Internet banditry, trading exchanges gone belly up, and the new currency’s “Wild West” feel, that doesn’t mean that it is going away anytime soon. To the contrary, CME Group began tracking it in November 2016, a telltale sign that the currency is gaining legitimacy. If it continues to catch on, then an adequate hedging tool for it is as important as having one for the US Dollar, coffee, corn, or gasoline.

To understand why we concluded it was not yet time to hedge Bitcoin price risk, see this separate blog post that explains five hedging issues for thinly traded commodities.

Future considerations for hedging cryptocurrency

If you own some currency price risk pertaining to a digital currency like Bitcoin and you aren’t speculating on favorable price changes, then I suspect you’ll conclude, like we did, that it’s still early in the game to find an adequate hedging solution. However, one may be coming down the road at the same speed as the growth of these digital currencies. Hang in there. Your patience will be rewarded.

CME Group’s tracking of an index for Bitcoin bodes well for the prospect of a futures contract at a later date. US-based CME Group is the largest exchange for hedging instruments in the world, offering contracts in most commodities. It has time-tested measures in place to protect market participants and may provide more comfort than today’s Bitcoin hedging alternatives. Regardless, always do your homework on possible trading partners before trading with them.

Recently, I tried to help an individual find a hedging solution for Bitcoin. That exercise proved fruitless for the same reasons that any new or otherwise thinly traded commodity may prove difficult to hedge. Here are five hedging issues for anyone who is seeking to protect thin commodities:

Issue #1: Counterparty credit risk

When hedging instruments increase in value, you must be able to collect the proceeds in a timely fashion. What is the financial wherewithal behind the counterparty to your trade, whether it be an exchange or a one-off trading partner? Up-front due diligence can help establish that the entity on the other side of your hedging position has the capacity to honor its commitment.

If you are dealing with an exchange, what procedures and safeguards does the exchange have making it likely that you can receive timely and full payment? If you have a dispute, how will you settle it, especially in an international setting? Note that some Bitcoin trading exchanges have already left investors holding an empty bag.

Issue #2: Insufficient liquidity

Futures markets need enough trade liquidity to allow for fair pricing and the ability to trade on short notice. Trade timing must be flexible enough to allow the hedger to trade his hedge positions simultaneous with “physical” deals on the index at risk.

When the hedger takes on risk with Bitcoin, for example, she must simultaneously enter a hedging position to oppose and thus offset the risk. The same holds true when the Bitcoin risk changes or goes away. In the cryptocurrency markets, this trade liquidity appears suspect at present.

Issue #3: Inadequate price correlation

Price correlation is a critical aspect of an effective hedge. Sometimes, however, a hedging instrument is a poor proxy for the price of the commodity or index it is designed to protect.

For example, the price of a futures contract factors in both current and anticipated supply and demand imbalances as seen by market participants. A future price of a commodity or index may differ substantially from current pricing for a variety of unpredictable and uncontrollable reasons.

In the case of Bitcoin, the market may still lack sufficient participation to provide pricing that truly reflects the marketplace and is devoid of significant manipulation by deep-pocketed speculators.

As an example, last week I looked at the price of Bitcoin futures on one futures exchange, Deribit. The Bitcoin contracts are quarterly (and three months may be too much time for a reliable price proxy on a hedged index). The price between the June and September contracts differed substantially. Today, when I compared those same contracts, they were close in value. So in the past week, those two contracts had poor price correlation. One of them changed much more than the other. And at least one of them would have been a poor price proxy for spot market Bitcoin.

Issue #4: Cash requirements

Many counterparties to hedging transactions will require margin (collateral) to protect their price exposure if their positions go against them. Often, however, they will not afford their trading partner the same treatment.

Understand and negotiate, if possible, the cash flow that may be required to hold your positions if the price of the hedging instruments goes against you. Presumably, that price movement will result in gains in the spot market. When you add this gain to your hedging loss, you are made whole. However, you may be unable to convert the gain to cash fast enough to pay for the loss on your hedging position.

Issue #5: Execution costs

Factor the cost of any trading, exchange, or margining fees into your hedging analysis. Make sure these fees are reasonable and do not leave you wishing that you had self-insured the risk.

Help is on the way

For additional explanation of related hedging issues, including the risks associated with hedging, the role of futures exchanges, and how hedge instruments work, check out my e-book on Amazon entitled Hedging Commodity Price Risk. It will help you understand hedging better and guide you through some relevant issues on your hedging program, no matter the commodity.

If I can be of service for any of your hedging needs or questions, please don’t hesitate to contact me via the contact form on this website or, if you prefer, through my hedging gig on Fiverr.

Any business that hedges a commodity price risk has made a decision to mitigate a certain risk. In the case of an airline hedging its jet fuel costs, it is attempting to prevent financial losses, should the cost of jet fuel increase. The airline’s hedger makes a financial commitment to buy the fuel over a certain time period at a fixed cost, usually the market price for those anticipated months of usage. The form of the hedge is typically a “long” position in financial derivatives or in some other contract that would enable the company to acquire the fuel at a locked-in cost. These derivatives could be futures, swaps, or forwards. Or, they could be options that would allow the hedger to acquire any of those derivatives at favorable cost later, should the market price increase.

In this case, Singapore Airlines had entered into a hedge to lock its cost at $116 per barrel. Current pricing is $63 per barrel. If prices stay the same through the remainder of the hedge period, they will lose $53 per barrel on the hedging derivatives from now until the end of the hedge. Yet, the hedge has worked exactly as originally designed: they locked their cost in at $116 per barrel. With perfect hindsight, I’m sure they wish they had not hedged the risk. Yet, there is a bigger picture. They may have recouped some or all of those losses through their ticket pricing strategy. Whether or not they have is beyond our scope and irrelevant to our discussion, but most hedgers are seeking to reduce risk rather than increase it. So, I suspect they had an offsetting benefit to curtail the negative effect of the derivatives.

Unwinding a hedge early usually means cashing up the derivatives and recognizing any embedded gains or losses. The company may simply be able to go out into the futures market and offset its positions by selling like contracts. Or, it may execute a swap agreement that negates the future effect of the existing derivatives until they expire or mature.

Once a hedge has been unwound, the risk that gave rise to the hedge is no longer mitigated. For example, it is possible, although perhaps highly improbable, that jet fuel could be priced at $150 per barrel by next month. Since Singapore Airlines is retaining its hedge, today’s large losses embedded in its derivatives would turn into gains, at least for the portion of time that jet fuel traded above the locked-in cost of $116 per barrel. Had it closed its hedge early, it would have lost $53 per barrel on the derivatives, and another $34 ($150 – $116) per barrel on the jet fuel itself. Even if prices only rebound to $70 per barrel, the company would be better off retaining its hedge because the derivative losses will not be as large as when jet fuel is priced at the current price of $63 per barrel. Without a hedge in place, any subsequent rebound in the cost of jet fuel will cost the airline additional money.

Although it is difficult to “be wrong” about the direction of a commodity price, true hedgers don’t think that way. They are not speculating on the direction of the price. Rather, they are eliminating the risk of an adverse price change.

If you are a hedger, be very thoughtful about unwinding a hedge. When you remove a hedge, you are removing the protection you originally put in place. There may be instances in which the hedged risk has declined significantly, whereupon early hedge removal may be prudent.

If you were running Singapore Airlines and considering removing its hedge on jet fuel, you would want to consider the following: Do I want to speculate that the cost of jet fuel is going to continue to decline through the end of our hedge period? Absent further information about the business, that is the only scenario under which removing that hedge early will benefit it. If the risk of jet fuel prices increasing above $116 per barrel was such a high concern at the inception of the hedge, wouldn’t today’s risk of prices increasing also be significant at the much lower price of $63 per barrel?

Although we don’t know all of the business factors (particularly revenues from customers) that would lead to these decisions, the fundamental questions are the same for any hedger of any commodity in any industry. Don’t compound one loss into another by a knee-jerk reaction that lacks the discipline of a effective hedging program. Weigh all factors carefully and remember the risk.

Note: There are accounting ramifications to unwinding a hedge early that may affect the timing of when related gains and losses are recognized, the disclosure of such gains and losses in the financial statements, and perhaps even the timing of inclusion of such gains and losses on the company’s income tax returns. Accounting for hedges is extremely complex, so consult with your accounting professional.

Everyone I know is an energy user. When you’re a business, energy is often one of the more significant expenses reducing your profit. Farmers, fishermen, and trucking companies consume substantial amounts of diesel fuel and gasoline to power their equipment. Retail entities must run lights, air conditioning, and heating systems, perhaps even refrigeration units. Manufacturers are powering machinery and equipment every single shift. And real estate companies may incur utility costs, depending upon the lease agreements with their tenants. Any businesses with substantial travel budgets are impacted by the cost of jet fuel to airlines, as well as diesel and gasoline costs to power their own fleets. You might say money AND ENERGY make the world go round.

Previously, I’ve explored the operational and hedging considerations of the recent decline in energy prices for both producers and marketers. In this article, I share some ideas on how business users of energy can strategize to maximize their future profits, given the more favorable prices of today’s market.

Strategic ideas for energy users:

1. Lock in your cost. Does the forward market for energy prices offer you price levels below your budget? Consider locking in your cost with long futures, swaps, forwards, or call options.

2. Reassess pricing for your own products and services. You’ve just been given a lower cost structure for your business. That’s good news! Now you need to decide what you are going to do with it. Should you use some of that benefit to increase your business? Will your competitors lower their prices? Is now an opportune time to increase your market share by lowering your prices? Or, is it simply time to hold on and enjoy the ride?

3. Solicit new business. Because of your lower cost structure, consider making new deals with customers. However, don’t be in a hurry to give away your recent windfall. Your memory may remind you of what happens when energy costs increase. Yet, you may be able to entertain business with certain customers for which you could not compete in the past. Reassess the market and seize new opportunities.

4. Consider new products or services. Do lower energy prices allow you to develop new products or services at affordable cost to the consumer?

5. Share the good news! Your lower costs should result in a stronger balance sheet and less costly operating structure. Some of your business partners will share in the benefits. To what extent they share may be up to you, if you’re proactive. Update your financial forecasts and share this information with key business partners. Will your lenders be willing to lower the cost or compliance of your debt? Is now an opportune time to reward shareholders and increase returns to them? Is this an opportunity to attract new capital to expand business. Will vendors grant you more favorable terms? Does your revised forecast qualify you to do business with customers who require their vendors to have stronger financials than you’ve had in the past?

6. Consider cooperative buying programs. If you do not have sufficient demand for energy services, it may be difficult to lock in your cost with market makers or vendors, nor may you be equipped to do so. Is it time to team up with other businesses in order to amass enough energy demand to command better forward pricing?

It may take more than simply blind faith or dumb luck to cash in on the benefits of lower energy prices. With commodities, one thing is certain: today’s price will not be tomorrow’s price. Current prices will not be with us forever. Sure, they could go lower. But don’t get greedy. And don’t be caught flat-footed, assuming that your bottom line in the foreseeable future is secure and profitable.

If you would like to bounce around any of the ideas presented here or in the two previous articles, please feel free to leave a comment or to contact me through the form on the contact page. I look forward to hearing from you.

In my last article, I presented some strategic ideas for producers, who typically benefit when energy prices rise and face difficulties when prices decline. In this article, I’ll look at energy marketers, who are often caught in the middle, literally and figuratively, when prices change. They are often selling energy to two classes of customer: those who are under contract based on prices in effect when they executed the contract; and those who purchase based upon current prices. Each class of business comes with its own unique risks. If a marketer also holds inventory, their balance sheets can be at risk for declining prices. Furthermore, a changing price curve can present unique opportunities to secure new business.

Strategic ideas for energy marketers:

1. Solicit new business. Lower prices typically benefit users. A marketer may now be in a position to offer users attractive pricing for future consumption. Consider marketing a new offering and protecting it with long positions in futures, swaps, forwards, or call options to lock in the market’s lower prices.

2. Bolster relationships with existing customers. If you have customers who locked in prices at higher levels than current pricing and who have unfulfilled commitments, make sure you are aware of the risk and keep tabs on customers who you fear may consider reneging on their commitments. Watch your accounts receivable balances closely. Work with customers to insure that they honor their commitments. Otherwise, you could be left holding a bag full of losses on financial derivatives with no offsetting business benefit.

3. Protect business at current price levels. If you have some unhedged fixed-price sales for which you are still at risk, consider placing protection at these lower levels. And, by the way, be grateful that the price didn’t go the other way!

4. Reassess price risk on inventory. If you own physical inventory of a commodity that has declined substantially in value, it may be time to reassess the risk on that asset. Hopefully, you’ve hedged the inventory price risk, so that now you have substantial gains on the financial derivatives used to hedge the risk. Consider cashing up those gains and either self-insure the remaining risk or purchase put options if you believe there is more downside price risk.

5. Lock in your cost. Just as producers are often substantial users of energy, so too are marketers. Their cost of delivering a commodity to market can be directly impacted by energy costs. Do current prices offer you the opportunity to attain a price level below your budgeted cost? Consider locking in your cost with long futures, swaps, forwards, or call options.

Check back soon for the last installment of this three-part series, in which I’ll address some strategic ideas for users of energy commodities.

If you run a business, you’re even more familiar with this price change, including its effects on your bottom line. The change has impacted producers, marketers, and users. However, just because prices have plummeted does not mean that risk–and opportunity–have vanished. That proverbial horse may already have left the barn, but there are more awaiting their own escape. If you have a future interest in a commodity, the uncertainty of its price will always present you with the counterbalancing risk/opportunity dynamic. Rather than simply wallowing in the anguish of lost profits–or basking in the glow of unexpected gains–perhaps it’s time to move on, to consider what opportunities this new pricing environment presents for the future.

In this article, I’ll consider the implications of current market prices for producers. Producers have a reasonably predictable cost of production, which does not change dollar for dollar with changes in energy prices. Therefore, absent hedging, when prices rise, their margins tend to expand, dropping straight to their bottom line. When prices fall, margins are compressed. When the price environment changes as radically as it has in the past six months, it’s time for a reassessment of one’s position and strategy.

Strategic ideas for energy producers:

1. Cash up paper gains early. Have you already realized substantial gains on financial derivatives that you used to lock in selling prices before the recent price decline? Is it time to cash in on those gains? Don’t create more risk by closing needed derivatives prematurely, but if your remaining risk is marginal, it may be timely to close your contracts if you can.

2. Use options to lock in gains. If you are concerned about the price of energy bouncing substantially from these price levels and losing some of your locked-in gains, consider converting short positions to long put options. Or, rather than closing your short positions, simply purchase call options on a speculative basis. Either practice will effectively lock in the gains on your short paper positions. If prices rebound, you’ll experience a windfall.

3. Suspend producing operations. Is it still profitable for you to continue producing energy in the new pricing environment? If not, consider curtailing or suspending operations to control cost and risk. More favorable pricing may await you down the road.

4. Lock in your cost. Chances are, if you’re an energy producer, you’re also an energy user. Do the current costs offer you price levels below budget? Consider locking in your cost with long futures, swaps, forwards, or call options.

In my next article, I will share some ideas for the middleman, the marketer.

Hedging Commodity Price Risk explains:
– What commodity price risk is and how it can affect your business
– What hedging is and how it minimizes risk
– Specific hedging examples
– Hedging pitfalls and opportunities
– How to reduce exposure to rising interest rates
– How to protect against changes in foreign currency exchange rates
– How to hedge weather risk

For more on the author’s credentials, check out About the author. To read testimonials about the book, click here.

For full details on the book’s release, read this news release. To pick up a copy of Hedging Commodity Price RIsk, go to the Open Road Press store.

Thank you to the many colleagues, family, and friends who helped make this possible.

Our contacts with these farmers suggested that they were not hedging their businesses, but would like to better understand how hedging could help them. Our extended conversation with the South Dakota farmer and his wife really convinced us that farmers bear a lot of risk.

There’s currently a glut of corn on the market, which has caused a drop in price from $7 to $3 per bushel. They are looking at marketing their crops in China and India, where prices are much richer. However, they have a logistical problem. These markets are serviced by ships sailing from the US Pacific coast, and there’s no easy route to ship their grains from South Dakota to the Pacific. Rail cars headed west are hard to come by, thanks in part to this changing marketplace and the oil boom in North Dakota. Meanwhile, the crops can be stored indefinitely only if the weather cooperates.

Which brings us to yet another risk that farmers bear: the weather. This couple’s crops were affected by a drought in 2012, and they are also subject to destruction from hail. The husband showed us a picture that he had taken on his iPhone just the previous evening of a funnel cloud tornado on his property. This got our attention since we’re traveling through the plains on bicycles, and there is often no cover within miles. It was a stark reminder that violent storms can and do arise in this area on a regular basis.

Regarding hedging his weather risk, he explained that there are limited National Weather Station data collection sites in many of the counties in South Dakota. Consequently, many weather derivative market makers will not make markets in many of these areas. He also suggested that there could be significant correlation issues between data collected at what NWS sites are available and weather conditions merely 50 miles away.

So if derivatives aren’t readily available, what about insurance per se? They’ve looked into this. They’ve not hedged their weather risks with insurance because they can’t economically purchase it. There are too many exclusions. When you try to cover all of the weather-related risks, the premiums become prohibitively expensive. I’m not sure whether they’ve exhausted their weather hedging alternatives, but clearly weather risk is a challenging issue for many Midwestern farmers.

When weather risk for farmers comes to fruition, a catastrophe will have long-lasting effect without the proper preparation. Perhaps the most effective weather hedge for farmers, and the most conservative given the premium assigned to these risks, is to self insure the risk over time.

What does that mean…self-insurance? The farmer needs to take a long view, and make a provision for catastrophe. When a bumper crop with healthy pricing showers in healthy profits, some of those profits are needed to underwrite lean years when disaster strikes. If you’re in the farming business, do you set aside funds in good–and average–years for the proverbial rainy day? Sooner or later, the storm will come! You can almost see the clouds on the horizon.