How not to Hedge
WSJ ran an article recently describing utilities losses on natural gas hedging. By “losses”, they mean derivative contracts that locked in higher prices for natural gas feedstocks while cash prices fell. Though the utilities did benefit from lower cash prices for their supplies, they lost big on the value of the derivative contracts, as much as $6B in the case of Florida Power and Light. In a classic case of rearview-mirror driving, some regulators are now suggesting a decrease in hedging programs. The article quotes two officials suggesting reducing or discontinuing hedging programs, since “gas prices [are] expected to remain low for years to come”.
The psychology of trading informs this type of behavior and sees it repeated again and again. When the market is bad (in the case of utilities, when prices are high), fear drives participants to increase hedging. The article also happens to mention that the post- Hurricane Katrina price spike was met with a rise in hedging activity on the part of gas utilities. Conversely, when the market is good (like now, at historically low prices), no one wants to miss out on prices improving even further, and hedging activity declines.
The same principles apply on the producer side of the energy supply equation. Financial media are in full Monday-morning quarterback mode, describing how little oil and gas production is hedged in 2016 and forward. Some smaller producers were forced to hedge due to lending covenants, but many larger players either did not hedge, hedged small amounts or short terms, or lifted hedges during the collapse in prices.
Why so few hedges left? In some cases, pure optimism. When Continental lifted its hedges in late 2014, CEO Harold Hamm expressed that doing so would allow the company to “fully participate in what we anticipate will be an oil price recovery”. Others likely feared locking in any price lower than the $100+ level and allowing derivative losses to become a drag on earnings relative to peers who had not traded the contracts.
One solution suggested in the WSJ piece on utilities was the employment of more complex hedging programs than the “lock and leave” type traditionally employed by large gas buyers. While the expert quoted doesn’t go into detail on what sort of strategies would be better, we can look once again at the supply side of the equation to see whether such plans can be more effective than more static methods.
A common hedging method employed by oil and gas producers is the collar. In this strategy, the E&P purchases a put option, locking in a floor price. A call option is simultaneously sold, limiting upside but offsetting in part or wholly the premium paid for the put. In recent years, more complex “3-way” strategies gained popularity. This method includes both of the above trades, but also sells another put option at some level below the strike price of the original floor. This addition gives the producer more cash to work with and the ability to have a higher strike price on the call sold, meaning that the producer retains more upside if the market rises. The only problem is that the effect of a fixed floor on crude is negated, and the producer is now exposed in the event that prices are very low. These were popular in the days of $100 crude, when it was difficult to imagine prices falling below $60, let alone $30 per barrel.
A February Bloomberg article names a few public companies who did employ this strategy and describes the difficulty that it has caused thus far, relative to more traditional hedging schemes. While producers like Noble, Pioneer, and Bonanza Creek are still realizing gains on their derivative contracts, they are now taking losses on the “subfloor” puts that have seriously eroded their protection against lower prices.
Unfortunately we come back to the same conclusion that the free lunch still doesn’t exist. Locking in favorable pricing means either giving up further potential returns, or accepting a drag on earnings relative to non-hedgers. In the very long run however, these are small relative to the safety that hedges provide. For if we recall the purpose of hedging in the first place, it is to lock in returns, dampen volatility, and insulate both producers and consumers from drops or spikes in prices that would sink the company.