The rising demand for commodity hedging: Navigating energy and commodity market volatility in 2024

In today’s highly unpredictable global landscape, commodities markets face unprecedented levels of volatility and complexity. Driven by geopolitical tensions, market disruptions, and economic uncertainties, businesses across various sectors seek advanced tools and strategies to monitor and manage risks, and optimize positions. In this blog, we delve into the current state of commodities markets and how businesses can effectively navigate these challenges using the right technology.

Understanding volatility and liquidity in energy and commodities markets

Energy and commodities markets are complex and dynamic environments where liquidity and volatility vary by commodity type. For instance, markets for Brent and WTI, along with related future contracts, exhibit high liquidity. On the other hand, markets for renewable power certificates, or physical gas at non-trading hub locations often face liquidity challenges, making it harder to execute trades without impacting prices significantly.

Geopolitical events and supply-demand dynamics are the main drivers of volatility in these markets. Following Russia’s invasion of Ukraine and the North Stream incident, global volatility levels surged. This geopolitical conflict disrupted supply chains, particularly for natural gas and LNG, which have become scarce across the Western world due to sanctions against Russia. Events like the Norway gas field incident or the Australian gas worker strike underscore the fragility of these supply chains, causing immediate spikes in European gas prices and, consequently, power prices. The Energy Information Administration (EIA) reports that Henry Hub prices rose by almost 70% between March and June 2024, while TTF Europe and Platt JKM Asia saw increases of 30%.

Despite the heightened volatility triggered by the Russia-Ukraine conflict, volatility levels have decreased since the initial invasion in February 2022. Factors contributing to this stabilization include reduced supply risks and improved renewable energy production. According to the European Network of Transmission System Operators for Electricity (ENTSO-E), renewable hydro production in Europe is set to increase, helping to stabilize power prices.

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Rising demand for commodity hedging

In the face of such volatility in the commodity market, a wide range of industries are turning to commodity hedging services to manage risk and ensure financial stability. Airlines and logistics companies, for example, rely heavily on fuels like jet fuel, diesel, and potentially carbon certificates. The International Air Transport Association (IATA) forecasts that global airline fuel expenses will reach $291 billion in 2024, highlighting the critical need for effective hedging strategies.

Similarly, the oil and gas sector has seen robust demand for hedging across the entire value chain. Exploration businesses, producers, and refiners hedge their exposure to crude oil, natural gas, and refined products to manage price risks and stabilize their revenue streams. According to a report from Mackenzie, crude oil hedging nearly doubled in Q4 2022, adding 309,000 barrels per day, while gas producers added over 4.02 billion cubic feet per day in new hedges, most of which were set for 2024 and beyond.

The agriculture sector, too, is actively engaging in hedging activities. Farmers and agricultural businesses hedge raw material inputs such as wheat, seeds, and fertilizers to protect against price swings that could impact their production costs and profitability.

Utility businesses are another significant sector seeking hedging services. These companies aim to lock in margins by hedging fuels for traditional generation, managing power and gas demand, and buying or selling renewable certificates. By doing so, they can mitigate the financial risks associated with fluctuating fuel prices, and ensure a cost-efficient supply of energy to their customers. The renewable energy certificates market size has grown exponentially in recent years. It is expected to grow from $13.71 billion in 2023 to $17.54 billion in 2024 – an increase of nearly by 30%.

Renewable developers and hedge funds are also responding to rising volatility in power markets. They increasingly use financial products to flatten their positions and secure profits. These entities also provide hedging services to third parties, helping other businesses manage their exposure to volatile power markets. According to Bloomberg NEF, investments in renewable energy projects reached $600 billion in 2023, indicating the growing importance of sophisticated hedging strategies.

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Capacity in financial markets to meet hedging demand

Standard commodity futures are highly liquid across major exchanges like ICE, CME, and EEX. This liquidity ensures that financial markets can meet the demand for hedging services, allowing businesses to manage their risks effectively. For instance, the CME Group reported an average daily trading volume of over 24.4 million contracts in 2023, reflecting the robust capacity of financial markets.

However, there are challenges associated with basis risk, where the exchange contract does not match the hedging needs precisely. For example, a business may face risks related to the price of a specific grade of crude oil that is not perfectly correlated with the futures contract they are using for hedging.

Another challenge is the lack of liquidity for long-term hedging timeframes. Long-term asset investments require hedging strategies that can span several years, but the liquidity (or coverage) in futures markets diminishes for contracts that extend far into the future. This can make it difficult for businesses to find suitable hedging instruments that match their long-term risk management needs.

Despite these challenges, the overall capacity of financial markets remains robust. Businesses can use various financial instruments and strategies to manage their exposure to commodity price risks. By working with experienced hedging service providers, they can navigate the complexities of basis risk and liquidity constraints, ensuring that their risk management strategies are both effective and efficient.

Use technology to mitigate risks

To manage the complexities of today’s commodities markets effectively, businesses need robust and integrated solutions. This is where advanced Commodity Trading and Risk Management (CTRM) and Energy Trading and Risk Management (ETRM) systems come into play. These systems enable companies to streamline their trading, risk management, and logistics processes, providing real-time visibility into market conditions. This visibility allows businesses to make informed decisions and react swiftly to changes, reducing their exposure to volatile market movements. ION offers a wide range of CTRM and ETRM solutions, including Allegro, Aspect, Agtech, TriplePoint, RightAngle, Openlink, and Carbon Zero. This diversity ensures that businesses of all sizes and sophistication levels can find a solution tailored to their needs.

For value-added benefits, these solutions can be combined with other value-added solutions like FEA for advanced risk analytics. FEA solutions offer sophisticated modeling and risk management capabilities that help businesses anticipate and respond to price spikes and market disruptions. These advanced analytics enable energy firms to optimize their portfolios and enhance their overall risk management strategies.

Conclusion

The current commodities market landscape presents both challenges and opportunities. Understanding the nuances of volatility and liquidity, and recognizing the industries with the highest demand for hedging services, is crucial for navigating these markets effectively. By implementing advanced CTRM and ETRM solutions, along with sophisticated risk analytics like FEA, businesses can mitigate risks, secure their positions, and thrive amidst ongoing volatility.