Boom, Bust, and Hedges - Part 3
This summer, I’m taking a snapshot of where the industry stands financially. First up was my take on how we arrived at where we are today, with an oversupply of both hydrocarbons and investment cash. In Part 2 I examined exactly why the price collapse was so painful, specifically why many companies did not take advantage of high oil prices to hedge their production. Today I’m examining how effective hedging decisions are made, why it’s time for a new approach, and how appropriate hedges can complement operations and drive profitability.
Part 3: How are hedging decisions made?
Hedging is typically driven by 2 factors: fear and constraint. Typically constraints like cash limitations, banking covenants, access to financial markets, and company culture are most prevalent. Like engineers, we tend to think of risk management as a proportionate weight of risk and cost. For instance when drilling a well, blowouts from certain formations are extremely unlikely. However, the cost associated with that rare event is catastrophic and unacceptable, and so we spend a portion of our budget on BOPs even given the small risk of needing to use them.
I can extend this analogy to finance, if the reader will play along and agree that $30 crude oil is functionally the same thing as a nasty blowout. Catastrophic to the company, potentially resulting in loss of (financial) life. As unlikely as it seemed back when WTI was $100, the risk was nonetheless real and, as they also say in the engineering department, nonzero.
I covered some of the risks, costs, and benefits of different hedging strategies in part 2 of this series. Since there are always trade-offs, the best way to make a decision is to assess the relative costs of each strategy. Every company has different priorities and will perceive these costs differently.
For instance, a small company with a very tight operations budget will perceive the risk of margin calls differently than a larger firm with more working capital or easier access to cheap financing. The “put-only” strategy may work best in that case, even though the operator must accept a lower total netback because of the option premium paid. In this case, there is no risk of having to post cash margin, and the company is protected from the catastrophic event of selling production below an unacceptable level. In this case, management would want to set the floor low in order to keep costs low and impact the netback as little as possible. If the hedge is viewed strictly as an insurance policy, then the floor (the strike price of the put) should correspond with an IRR at a bare minimum level, at which crude sales would just cover operating expenses and keep the lights on. Alternatively, the operator may pursue other strategies but insulate from margin calls using an intercreditor agreement to pledge assets against possible exchange requirements. If the hedges are out of the money, the assets will have gone up in value a proportional amount.
A larger firm may view hedging on a portfolio basis, with particular properties. A power generator who can sell electricity at attractive prices from a particular plant in a deregulated market may buy gas futures in the forward market to lock in an attractive “spark spread” at which the plant can produce at good return. They may hedge the plant’s capacity and have a known revenue stream and IRR for that part of the portfolio of assets, but leave others open in order to maintain upside.
Likewise, an E&P company may consider selling futures and basis on a particular producing asset to lock in returns from a given basin or on a particular acquisition. This could ensure that the asset will continue to produce in any future commodity price scenario. In either case, the risk of margin calls on that particular hedge, based on that particular asset, is considered as part of an overall cash management strategy. The company need not take the margin call risk on the entire portfolio of assets, but operations throughout the company and access to debt can cover the potential cash needs and allow locking in of attractive returns.
Another approach for a larger company is to use the “collar” strategy that I also described in part 2. For a company more interested in buying an overall insurance policy and willing to forego some upside, it preserves netback and keeps the company or properties competitive in the greater market. Rather than just locking in an absolute floor, it allows for a “band” of effective price for the commodity sold, and therefore allows the company to produce and operate within a range of IRRs, providing certainty and ensuring profitability. This overall-company approach allows for asset management as well, as prices within the range dip below profitability for certain assets, then capex for those assets can be reduced or suspended and cash diverted to the margin account until conditions improve and the cash can again be profitably deployed across the entire asset base.
There is no “designer” strategy that works perfectly in every situation and accomplishes every business goal. I’ll go back once more to an old engineering concept, this time elegance. The simplest solution that meets the particular need is the best one. In the case of hedging, simplicity accomplishes something that complexity cannot, which is facilitate the ability of financial hedges to inform management decisions. In complex and active strategies, management may “lose track” of the impact of market moves and what exactly the netback and effective sales price of their products are. With the waters thus muddied, decisions are more difficult.