Hedging is hot. Shifts in supply-and-demand dynamics and global financial turmoil have created unprecedented volatility in commodity prices in recent years. Meanwhile, executives at companies that buy, sell, or produce commodities have faced equally dramatic swings in profitability. Many have stepped up their use of hedging to attempt to manage this volatility and, in some instances, to avoid situations that could put a company’s survival in jeopardy.
When done well, the financial, strategic, and operational benefits of hedging can go beyond merely avoiding financial distress by opening up options to preserve and create value as well. But done poorly, hedging in commodities often overwhelms the logic behind it and can actually destroy more value than was originally at risk. Perhaps individual business units hedge opposite sides of the same risk, or managers expend too much effort hedging risks that are immaterial to a company’s health. Managers can also underestimate the full costs of hedging or overlook natural hedges in deference to costly financial ones. No question, hedging can entail complex calculations and difficult trade-offs. But in our experience, keeping in mind a few simple pointers can help nip problems early and make hedging strategies more effective.