How do hedge funds manage risks in energy markets?

How do hedge funds manage risks in energy markets?

Participating in energy markets can be lucrative if handled in the correct way, but also comes with its own unique set of risks, which can include price volatility, geopolitical events, and regulatory changes. 

Fortunately, there are a number of ways to manage and mitigate risks within the highly unpredictable energy markets.

A portfolio of different types of financial instruments and quantitative models can be applied to help reduce these risks. It can be applied to protect capital and generate returns in an unpredictable sector. We explore some of the sophisticated strategies hedge funds use to manage risks in the energy market and how they may apply to your business. 

Understanding risk in the energy markets

Price volatility

As with most traded commodities, there are inherent fluctuations in crude oil, natural gas, and electricity prices. However, there are financial tools available to help manage these risks, for example, the Crude Supply Risk, which is a dataset that tracks changes in oil price fluctuations every week. 

Geopolitical risks

Many of the countries that produce some of the world's most abundant fossil fuels are also among the most politically unstable. If the country receiving energy from the producing country experiences political friction with the producing country, it can affect the pricing or availability of energy in that country. One thing is clear - international relations, conflicts, and political instability have an obvious impact on energy supply.

Regulatory and policy risks

When tariffs and environmental regulations are reassessed by the government, they can alter market dynamics by changing the costs associated with producing or receiving energy. They can also cause local sources of energy to be favoured as part of specific grants or schemes, changing market dynamics overseas.

Supply chain risks

The energy supply chain can be threatened by factors such as economic changes, natural disasters, infrastructure failures, or cyberattacks. As a result, disruptions can occur to production, storage, and transport of energy commodities, causing increased costs, shortages and even halts to production. 

Core risk management strategies for hedge funds

Hedging with derivatives

Potential losses can be further protected against by using financial instruments such as hedges to mitigate losses. Futures can be used to lock in a future price of energy, while options give energy buyers a non-mandatory option to buy energy at a specific price, and swaps can help to lock in prices and protect against adverse price movements.

Diversification

By implementing hedging, you can go some way to stabilise pricing for energy purchases, but spreading investments across different energy sub-sectors can also help to reduce your risk, for example, spreading investments across oil, gas and renewables. Spreading risk across geographies can also help to reduce concentration risk further.

Quantitative modelling

Tools to help test financial losses are also available, by simulating the potential risk of loss based on the maximum financial loss that a buyer might experience during the financial market at that time. More sophisticated tools, such as value at risk (VaR) and stress testing, can measure and forecast potential losses under various market scenarios.

Scenario analysis

Sometimes, unlikely but high-impact events can have a huge impact on energy pricing. This could include such a major geopolitical conflict or a sudden supply shortage. It can help to identify, prepare for and respond effectively to these hypothetical crises before they occur. 

Key financial instruments and tools

Futures and forwards

Futures are a financial tool that can be used to prevent the cost of energy from rising over time. They set the future price of energy via a contract in which it’s bought or sold at a predetermined price on a future date.

Options

If a buyer or seller is not 100% committed to buying or selling a specific energy parcel, options can be a more flexible way to fix energy prices. Options provide the right, but not the obligation, to buy or sell an asset at a specific price.

Swaps

Swaps are a more complex contractual agreement that help protect against adverse price movements. In this type of agreement, cash flows are exchanged based on the price of an energy commodity.

Algorithmic trading

Automation can also be used as part of a risk management strategy, which removes the human element and allows trading to be done on a quicker and more reactive basis, securing the best pricing. Algorithmic trading utilises computer programs to execute trades automatically based on predefined criteria, often employed to manage fast-moving price risks.

The role of a risk management framework

Defining risk tolerance

Often, businesses can cope with a certain amount of risk; it’s all about establishing how much financial loss a company can withstand. Defining risk tolerances enables businesses to plan proactively for these risks, establishing clear limits on exposure and potential losses.

Leverage management

When borrowing capital for energy-based projects, over-borrowing can put you at a higher risk. Often some element of risk needs to be introduced because of the volatility associated with the energy market. Leverage management involves carefully controlling borrowed capital to avoid amplified losses during market downturns.

Operational risk

Sometimes it’s not market behaviour that has an impact on risk, but the operation of your organisation or the company you’re doing business with that increases risk. Mitigating the risks related to internal systems, people, and processes can help reduce risk. Using frameworks such as Operational Risk Management (ORM) can facilitate the implementation of these changes more successfully. 

Regulatory compliance

When it comes to the energy sector, not playing by the rules regarding regulatory compliance can come with hefty financial penalties. These frameworks have been introduced to prevent illegal activity within the sector and maintain transparency for those who participate in it. That’s why all trading activities must adhere to strict financial regulations to avoid legal and financial penalties.

Hedge funds manage energy risk with a comprehensive approach. They use derivatives, diversification, and quantitative models to navigate volatility and protect capital.