by JAY PIERCE
Interval Purchasing is the practice of buying or selling swaps or forwards to financially purchase a supply chain for a specific period. It is not hedging – it is procurement. For example, a commodity user buys 90 days of Nat Gas futures on January 2, April 2, July 2, and October 2 and so on. Even though it looks like the buyer covered his supply chain for a year, he did not. Rather than a full year of coverage, there were four consecutive three-month periods covered. The purchasing coverage is only effective for the three-month period currently active and nothing more. A simple numerical example illustrates this.
On January 2, the price was 5 when the three-month forward is bought. On April 2, the price was 10 when the forward is bought, on July 2 the price was 15, and on October 2 the price was 20. The average price paid by the interval purchaser for the year was 12.5, much better than the final price of 20. Looking closer we find -
Let us now compare this scenario using Continuous Hedging and observe the differences.
Continuous Hedging views the commodity supply chain as a permanent recurring cost center and seeks to insure it against price shocks in a recurring, never-ending, manner. Continuous Hedging’s goal is to protect the firm. It is not procurement, it is financial insurance.
Looking back at our last example, the year’s requirements (10,000mmcf) would cost $50mm if purchased at once. The Continuous Hedger would buy calls covering the entire period. The cost of the calls is 10% in this example. Adding the cost of calls, the year’s requirement cost is now $55mm.
On January 2, the price was 5 when the Continuous insurance is bought. On April 2, the price was 10, on July 2 the price was 15, and on October 2 the price was 20. The average price paid by the Continuous Hedger for the year was 5.5, dramatically better than the final price of 20. Looking closer we note the following:
If the price level had gone down instead of up, the calculation is easy. The commodity supply chain cost will be over-all lower than the year before, a benefit to the firm, but will be higher than doing nothing by no more than $5mm, the cost of the hedge. Taken another way – here are two scenarios, one is a savings of $70mm and the other is a cost of insurance of $5mm. One only needs to see the first scenario once every 14 years for it to be better for the corporation to continuously hedge rather than not.
Let’s frame this further – on the chart below using the previous 10000mmcf supply chain example, since 2000, there have been six price events. Please compare the costs of the Continuously Hedged position and that of the position using interval procurement or similarly, no hedge. The premium cost assumption of 10% is embodied in the calculation.
There is no complex derivative or cost-saving strategy that can come anywhere close to these results. Clearly, for the hedger not using this strategy, the extra cost on 10,000mmcf/yr. is at least $144,200,000 over the 17-year period. For many readers, this may be your scenario.
Many Boards have said that the initial cost of Continuous Hedging is burdensome. Insurance does have a cost. But that burden is not relevant any longer because non-bank, non-secured margin financing, that will pay the cost of the insurance up-front, is available to corporations at very competitive rates. We facilitate this as part of our value.
Here is the call to action to corporate Boards of Directors, CEOs, and CFOs – Do not confuse procurement with insurance. For the best practice of protecting your company’s financial health, employ Continuous Hedging to protect your commodity supply chain against price shocks. We are experts in Continuous Hedging. Call on us to assist you!