What is hedging?
Hedging is a risk management strategy that offsets potential losses (or gains) from a physical or commercial position by taking an opposite position in a related instrument (futures, options, swaps, forwards).
The goal is not to make a profit from the hedge itself but to reduce volatility and lock in a more predictable outcome (e.g. effective price or cash flow).
In commodity/energy trading: the physical desk has exposure (e.g. buying 1M bbl crude for March).
The paper (hedging) desk trades derivatives to offset that exposure so the firm is not left speculating on price.
Hedging instruments in practice
Hedges are executed with futures, options, and swaps. The choice depends on liquidity, basis to your physical price, and how much upside you want to keep.
- Futures: Lock in a price for a standardised delivery. Example: a refiner buying North Sea crude (Brent-related) hedges by buying Brent futures; the futures gain offsets higher physical cost if oil rises. Volume is matched to exposure; for a different grade or location, a hedge ratio (e.g. 0.98) adjusts for historical correlation so you don’t over- or under-hedge.
- Options: Cap downside while keeping upside. Example: a producer selling gas buys a put option; if prices fall, the put pays out and offsets the lower sale price; if prices rise, the put expires worthless but the producer benefits from higher physical revenue.
- Swaps: Exchange floating price for fixed (or vice versa) over a period. Common in gas and power: e.g. fix the price of a monthly gas volume with a TTF swap; the swap leg offsets moves in the floating index.
Hedge ratio: When the hedge instrument doesn’t match the exposure 1:1 (different commodity, location, or tenor), the optimal hedge volume = exposure × hedge ratio. The ratio is often estimated from historical regression (e.g. physical price vs futures price).
Cross-hedging is when no exact instrument exists (e.g. hedging a regional power price with a liquid hub futures); basis and correlation risk must be monitored.
The exposure formula
The ETRM exposure report answers “how long or short are we?” — the volume (and optionally value) of commodity that is unhedged and exposed to market moves.
Example: 1M bbl physical purchase − 800k bbl futures bought = 200k bbl unhedged exposure.
The paper desk hedged 80%; 200k bbl remains exposed to price moves.
Who does what
Why accuracy matters
The exposure report is built per book (e.g. Natural Gas, Crude, OTC Power) or by geography and is calculated in the overnight EoD process.
It must be accurate and on time (e.g. by 7 AM).
If exposure is wrong, the amount hedged is wrong: the firm may think it is hedging but is effectively speculating without knowing it.
Market moves can then cause large, unintended losses.
Basis risk and other limitations
Basis is the difference between the price of your physical (or commercial) exposure and the price of the instrument you use to hedge. When you hedge, you fix or offset the hedge instrument’s price; your actual outcome also depends on how that basis moves. If the basis widens or narrows unexpectedly, the hedge is less effective:
the physical leg and the hedge leg don’t move in lockstep.
Example — Henry Hub vs TTF gas: A European buyer may have exposure to TTF (Title Transfer Facility) prices but hedge with Henry Hub futures or swaps because they are more liquid.
Basis = TTF − Henry Hub (adjusted for units/currency). If TTF spikes due to European supply stress while Henry Hub is stable, the basis widens: the hedge doesn’t fully cover the TTF move, and the firm retains basis risk. ETRM and risk reports often show exposure and hedge by price index so basis can be monitored.
Hedging limits upside: Locking in a price protects against adverse moves but caps gains if the market moves in your favour.
Correlation and tenor: Hedge effectiveness depends on correlation and matching delivery/tenor; ETRM must capture pricing terms and dates correctly for exposure and P&L.
Static vs dynamic hedging
So far we have described static hedging: set a hedge once to match exposure. In practice, exposure changes over time (new deals, amended volumes, nominations, outages).
Dynamic hedging means rebalancing hedges as exposure and market conditions change — e.g. increasing hedge volume when physical purchases grow or rolling futures as delivery months approach.
Operational challenges include: timely exposure and position data, clear ownership of who rebalances (physical vs paper desk), and the cost of trading (bid–ask, slippage).
Over-hedging or under-hedging can occur if rebalancing is delayed or if exposure is calculated incorrectly.
ETRM systems support this by tracking hedge coverage ratios (hedged volume ÷ physical or notional exposure) per book, commodity, and tenor.
Reports and dashboards show current coverage vs target (e.g. 80% by month); alerts can fire when coverage falls below a threshold so the desk can add or reduce hedges. This keeps the portfolio aligned with policy without manual spreadsheet tracking.