With the Russia-Ukraine war raging on, economists have been thrown into unchartered waters as the conflict rewrites all the energy market’s financial equations. The war has forced global energy prices to go through the roof, creating one of the most daunting economic crises the world has ever seen. With the world’s economy in flux and gas-starved Europe bracing itself for a long winter, corporate leaders, government officials, and the world’s top experts have been hard at work to implement a strategy that can help navigate the world out of this deep abyss, but crisis management is a complex science with its different opinions and approaches. In the world of energy economics, taking the right measures to counter a negative trend is a key part of mitigating its fallout. And for many economists, hedging does just that.
Hedging can be thought of as a type of insurance. It is a risk management strategy that involves reducing the impact of market crises through the use of financial instruments and approaches to offset dangerously severe price fluctuations, particularly those caused by significant global events. These financial tools are known as derivatives, of which there are two types, options and futures.
In energy markets, there are six main futures contracts, four of which are traded on the New York Mercantile Exchange, WTI crude oil, Henry Hub natural gas, NY Harbor ultra-low sulfur diesel, and RBOB gasoline. Brent crude oil and gasoil are futures that are traded on the Intercontinental Exchange (ICE).
Future contracts give buyers the right and obligation to purchase a commodity at a fixed price given in the contract regardless of the price fluctuations in the market. This same rule applies to the seller. The seller of the contract will have to sell the commodity to the buyer of the contract at the agreed price specified in the contract. In addition to futures, hedging in the oil and gas industry can include swaps, put options, and costless collars.
It’s not just a source of financial security for just individual buyers and sellers. Hedging has also proven to be an effective tool to improve the immunity of economies around the world from the price fluctuations of various commodities. Since oil and gas price fluctuations can have a domino effect on other markets, hedging plays an essential role in mitigating the economic fallout of inflation.
Hedging has taken center stage recently as an essential component of Egyptian economic policy, particularly in the energy market. In 2018, the Egyptian government took steps to protect fuel subsidies against oil price fluctuations by using insurance contracts that would help the country hedge against prices exceeding $73 per barrel (/bbl). During the following year, both the Ministry of Petroleum and Mineral Resources, as well as the Ministry of Finance, also changed the hedging mechanism in the fiscal year 2020/19 due to oil price fluctuations. Then in 2019, the Egyptian government finalized a contract with two international banks to hedge against soaring prices, targeting prices of less than $70/bbl (within the range of $64-$68/bbl). These measures ensured that the market conditions at the time would not burden the state budget.
The question remains: would hedging be considered an adequate and effective escape route that could mitigate the effects of an energy economics crisis, such as the one the world currently faces? While hedging is noted for its effectiveness in its security against adverse price changes, it should be noted that it is designed only to reduce loss, which also means there’s a possibility it can limit gains as well. Hence, opinions will differ from one economist to another as to how much benefit hedging can bring to an economy.
As Egypt is set to become one of the main exporters that will quench Europe’s thirst for liquefied natural gas (LNG), hedging can be thought of as a double-edged sword. On one hand, the Egyptian government could use hedging to fix LNG at its current high prices to protect its profits even when natural gas prices begin to take a dip in the future. On the other hand, it is always well-known that the downside to hedging is that it is only good for minimizing losses (or protecting profits) rather than maximizing profits. If natural gas prices rise even more in the future, then using the current fixed prices might make Egypt miss out on potentially big gains. It’s a complicated balancing act that both officials and producers have to perform and get right in order to be triumphant.
With inflation on the rise and an unstable market suggesting an insecure outlook in the near future, implementing the right monetary strategies to bring immunity to Egypt’s economy is essential for maintaining both national and regional stability. Though hedging is one of the more effective strategies in providing the economy with some level of financial security, Egypt’s long-term prosperity depends deeply on rapidly developing economic self-sufficiency and a highly competitive market today so that it will be able to ride the rough tides of tomorrow.