There’s no magic in dollar cost averaging.
Richard Goldberg and James Read are principals with The Brattle Group, in San Francisco, Calif., and Cambridge, Mass., respectively.
A new approach to hedging commodity price risk appears to be gaining popularity in the natural gas and electric utility industries. This new approach, dubbed “dollar cost averaging” (DCA) by analogy to a popular personal investment strategy, appears to offer substantial cost savings over alternative hedging approaches. However, evaluating DCA critically, to locate the source and assess the magnitude of its apparent cost advantages, reveals that DCA doesn’t reduce commodity costs compared to time-averaging—a widely used and simpler approach to hedging commodity price risks.
Like the audience at a magic show, proponents of DCA have fallen prey to misdirection; because they focus on one component of commodity procurement costs, they fail to see another. Specifically, they miss the fact that the hedge cost advantage of DCA is fully offset by the balancing cost disadvantage—i.e., the cost of covering remaining commodity requirements through other forward or spot market transactions. Furthermore, not only does DCA fail to provide a cost advantage, it’s less effective than time averaging at mitigating extreme market price outcomes.