The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron

by Bethany McLean

Hedging itself is an old financial technique. It’s exactly as the word sounds: it’s a way to reduce risk. Suppose the price of oil is $20 a barrel and you’ve promised a customer that you’ll sell it oil at that price for the next two years. In effect, you are now short oil. If prices fall, you’re in great shape, because you’re selling the oil for a higher price than it’s costing you. But if prices rise, you’ll have to sell the oil for less than it costs you to fulfill your promise. So if you don’t want to take that risk, you can hedge by taking an offsetting long position, or agreement to buy oil, at the same price. Thus, it doesn’t matter to you whether the price goes to $60 or to $10; either way, you’re still paying and receiving $20 a barrel. But being fully hedged also means you’re making no profit on any price move in oil; all the profit comes from the deal you’ve cut with the customer. If you think you know where prices are headed, you might not want to be fully hedged. The other issue is that commodities markets are complicated beasts, and it is often impossible to be truly fully hedged.