Strategic Hedging

 

A holistic approach can rein in the overall risk-reward proposition for investors, employees and management.

The vast majority of commodity-price hedging by small , midsized exploration and production companies is strategically ineffective. Equity investors typically express ambivalence about hedging policy, and management teams often express frustration with the process and results.

oil

 

Secured-debt investors would be the only participants that appear genuinely enthusiastic about hedging; however, while they often are commercial banks which can be bundling hedging services with loans, it's not obvious whether their enthusiasm is driven by improved risk management or by additional fee capture.

It is time for the industry to abandon myopic, tactical approaches and embrace an all-natural perspective on managing commodity price risk, a method we characterize as “strategic hedging”.

finance

 

Roots in agriculture

Price hedging techniques and methods emanated from the agricultural markets. Farmers wished to lock in price certainty on the portion of their crop during planting in an attempt to avoid financial ruin from adverse price movement before harvest. The duration of the forward activities was governed by the duration of the growing season, resulting in contracts typically which range from three months to one year.

For the reason that farmer could alter his decisions on crop allocation every single season, the use of the hedge naturally matched the amount of the commitment period. Thus, hedging implementation practices evolved that focused mainly on basis risk (the main difference between the actual product price and also the standardized product price) and quantity.

Falling share of the market of oligopolistic oil trusts and the deregulation of natural gas markets inside the latter half of the 20th century increased the realized volatility in energy commodity prices. Markets for standardized energy contracts emerged, mimicking the expansion of agricultural futures exchanges. Notably, though, the strategies for designing and implementing hedging policies, that had been molded in the agricultural futures pits in Chicago, are not substantially altered. Today, exactly the same methodologies are employed in the two finance and treasury departments of E&Ps and on the desks from the commodity trading departments of economic and investment banks as were developed and honed from the agricultural commodity markets of yesteryear.

The normal method is to start at time zero (now) and move ahead in time, estimating the number of production and the most closely correlated standardized contract. Because the futures markets’ liquidity has a tendency to decrease the farther one moves into the future from time zero, the majority of planning and implementation is centered on the near term.

Common practice, by way of example, would be to estimate monthly production volumes for 12 to A couple of years at the most, and then to select the best contracts to hedge a portion of that volume. In the agricultural arena, the place that the duration of a project (i.e. enough time from planting to harvest) is limited, this technique can effectively and dramatically reduce financial risk. Unfortunately, from the energy production arena, project duration is measured in years and sometimes decades, not in months or seasons.

Income versus value

Because the duration of production greatly exceeds the scope from the typical hedging program, modern commodity-price hedging programs are merely locking in a small area of future cash flows. The world wide web present value of the sum total of all future expected cash flows therefore is confronted with unmitigated future price volatility. Assuming the typical North American E&P company comes with a eight-year R/P (reserve-to-production) life, even if 100% of production is hedged for the first two years, then below 30% of the value of the assets is hedged, even considering intrinsic declines being produced.

From a fundamental equity investor’s perspective, the advantages of a conventional hedging program are in most a slightly lower risk of bankruptcy during the covered period. Considering that many equity investors use E&P stocks as proxies for commodity-price movements, a few will even express displeasure when hedging programs of any type are contemplated. It is no surprise that managements of E&P companies are both underwhelmed by and unenthusiastic about commodity-price hedging.

Secured debt and capital cost

Secured debts are the least expensive form of financing for E&P companies, with floating rates typically costing Libor plus 100 to 300 basis points. Weighed against unsecured mezzanine debt at approximately 18% and also equity at 25%, secured debt is extremely inexpensive, and thus, widely desired. The most commonly used vehicle for accessing secured debts are the syndicated bank-borrowing- base facility, a revolving loan which has a two- to three-year term commonly known as in the industry as an “RBL” or reserve-backed loan. These refinancing options use an independent third-party engineering report, combined with bank’s own assessment of future pricing, to evaluate the “base” amount of the borrowed funds facility. Generic terms will be the lesser of either 50% of P1 (total proved reserves) or as much as 65% of PDP (proved, developed and producing reserves), employing a price deck of approximately 70% of the forward Nymex curve.

By way of example, a company desiring a secured loan against an E&P asset owning an engineering report demonstrating a PV-10 (the present value of future cash flows at a standardized 10% discount rate) of $100 million on PDP reserves employing a conservative 70% forward pricing curve, should expect to be awarded a $65-million personal credit line. These loans have various customary restrictive covenants. Most of all, however, the base amount is “reset” periodically (typically each), adjusting for asset acquisitions and divestitures, the longer term quantity and cost of reserves, and pricing-deck assumptions. Due to the extreme volatility of your energy commodity prices, the latter impacts the calculation most dramatically, both on an absolute basis and from a surprise/uncertainty perspective.

In our example, if the forward price curve had declined 40% by the end of the first six- month reset period, our PDP value would fall to $60 million, and our RBL would be reset to $39 million. The company would then be forced to pay back the $26-million contrast between the original $65-million RBL and the adjusted $39-million RBL. This could be problematic if the company doesn't need sufficient operational liquidity during the time of reset, forcing the issuance of high-cost mezzanine debt or equity. In periods of unstable markets, the only other options are asset sales, corporate sale or bankruptcy.

Commercial banks and investors that loan cash a secured basis usually are not investors in your company. Despite each of the friendliness and fanfare shown through your relationship banker, its only job when originating or doing a borrowing-base facility is usually to ensure that it loans capital by using an almost risk-free basis. That’s why the rate is priced in countless basis points above Libor, the pace at which banks lend money one to the other on a short-term basis.

The bank’s security is based on keeping the actual amount of the loan short (six-month resets) plus making sure there are enough assets backing its capital to ensure should those assets must be liquidated, it would recover 100 cents on the dollar loaned. When a bank encourages an organization to hedge, generally simply because it increases its fee. Unless it is reducing its rate or increasing the RBL borrowing-base calculation formula to are the cause of the additional security, it is merely interested in the fee.

Fundamental equity investors are only somewhat better off, meaning that a cash-flow hedge covering 2 yrs of production may avert triggering a cash-flow-related loan covenant for the short term. However, given that a good generic RBL has value-related covenants (debt-to-capital; debt-to-equity) de- signed to protect against balance-sheet (not cash-flow) insolvency, the protection is minimal at the best. When a company employs a RBL to capture the main advantages of a lower blended expense of capital, it is shouldering additional commodity-price-liquidity risk. Unless the whole value of the RBL has become hedged, this risk is borne with the equity holders.

Exactly what is the way to quantify the price tag on that risk? Yes: it’s the cost of adding commodity- price insurance for your total balance from the RBF versus the substitution expense of unsecured mezzanine debt. Commodity-price insurance plans are available in the form of premiums covered put options. While many managements would think this can be outrageously expensive like a benchmark, consider the approximate 18% price of capital demanded by unsecured lenders. These unsecured lenders, not like the secured RBL syndicate, are investors within your company. Since their investment is not completely covered by the nominal liquidation with the assets of the company, there is a true stake and alignment from the management of those assets for future growth and value.

In other words, an unsecured, preferential investor in naked E&P assets demands a hurdle return of 18% plus a private-equity investor demands 25%. Any funds that come below those minute rates are not bearing any true operational, fundamental or commodity-price risk. Any company that uses low-nominal-cost, secured RBL financing should recognize that it is materially increasing the likelihood of distress and bankruptcy because of its true investors. The price of that increased risk is explicit since the difference between the price of financing only using unsecured mezzanine debt along with the price of financing employing a RBL that has been fully hedged using energy price puts. A firm can also shift that risk to third parties by using swaps, forwards and collars- i.e. by increasing its hedging program to cover the total value of the RBL. While forward sales and other tools do not have a sudden income-statement impact, as compared to the price of premium paid on commodity-price put options, the corporation has given up significant operational and strategic flexibility and so, has chosen to bear as significant a cost as the explicit cost of put-option premium.

Introducing strategic hedging

Both basic elements in a strategic hedging program are: 1) understanding that hedging is about minimizing the risk associated with major decision-making, and two) that hedging is most properly viewed in the context of the cost of capital, not as a line-item cost around the income statement.

Here we are at the roots of commodity-price hedging, the farmer’s goal was not to smooth seasonal earnings, but rather to make sure that the logical strategic decision he made to plant crop x, which has been based on all of the information he'd access to at the time of planting, would not result in financial disaster at the end of the harvest solely because prices had changed. Likewise, when an E&P firm helps to make the strategic decision to build up and produce an coal and oil field, or to purchase or merge which has a competitor, it can usually into consideration the price environment that exists during investment. A strategic hedging plan would con- sider the complete duration of production as well as the value of being able to follow an initial plan no matter unpredictable short-term price volatility.

Management teams that employ conventional hedging methods often complain from the insurmountable cost of put options, or opportunity costs of swaps and forwards. They must move away from a myopic pinpoint the income statement and set those costs negative credit the income statement, cash-flow statement and balance sheet; that is, they need to understand how hedging may affect their cost of capital.

Surprising as it can certainly seem, ExxonMobil is an active strategic hedger though it does not use any commodity-price derivatives. ExxonMobil plans and executes its strategy with plenty liquidity and flexibility to totally ignore short-term commodity-price volatility. Exxon also chooses to keep up a strong liquidity position and does not rely on secured debt since the primary financing mechanism underlying its business structure. The relatively 'abnormal' amounts of net debt carried through the company are not accidental, but a strategic decision.

Strategic hedging is around putting reins on the overall risk-reward proposition for investors, employees and management. Strategic hedgers are curious about designing favorable risk-reward outcomes, not in managing earnings. The present popular methodologies overemphasize monthly volumes and basis risk, and underemphasize the price of decision-making optionality and flexibility. The result is that hedging has turned into a tool for smoothing quarterly results along with a major profit center for your secured lenders.

Meanwhile, firms that follow conventional “conservative” policies usually see themselves on the brink of distress, insolvency, liquidation and bankruptcy when their bank syndicate makes its semi-annual capital call. Financial management is usually an afterthought at operationally focused E&P companies. Management can be well advised to invest exactly the same effort in engineering the security and soundness of its capital structure because it does in the gas and oil fields that compose its assets.