Most companies recognize the importance of delivering consistent performance results, yet the ability to fulfill this objective is sometimes undermined by product price uncertainties. Many companies effectively manage the impacts of price uncertainty through the use of financial hedging instruments, while others have avoided hedging due to lack of knowledge, lack of company infrastructure, or political pressures. This paper addresses the reduction of uncertainty that may be obtained through portfolio management practices as contrasted to that achieved through financial engineering or hedging. A case study and computer simulation will be used to describe a portfolio management methodology for reducing the impacts of pricing uncertainty on performance results. The results will then be compared to strategies ignoring the variability of price, as well as strategies employing the use of typical hedging instruments.
The ability to reduce pricing risks through portfolio management is dependent upon project diversity (scale, timing, capital and fiscal structure) as well as the stated objectives of the organization. The results from the case study indicate that given an adequate cross section of opportunities, significant reductions in performance variability due to product pricing may be achieved through portfolio optimization. These uncertainty reductions may then be further enhanced through price hedging, as necessary to bring the overall level of uncertainty within a range acceptable to company decision makers or the market.
This case study and the resulting comparisons will demonstrate the way in which risk reduction through portfolio management may be used in conjunction with financial hedging to dramatically improve a company's ability to deliver consistent results.