To Hedge or Not to Hedge

Download To Hedge or Not to Hedge

Post on 15-Mar-2016

217 views

Category:

Documents

0 download

Embed Size (px)

DESCRIPTION

Hedging Advice for Oil & Gas CFOs

TRANSCRIPT

  • by Michael Corley

    presents

    to hedge

    to hedgeor Not

  • to hedge

    to hedgeor Not

    Oil & gas is a volatile and cyclical business and will always present both hedging opportunities and risk management challenges. The Global Commodities Report asked a veteran energy trader and risk manager for pointers on how to use hedging to mitigate risk and avoid the

    pitfall of speculation.

    Hedging advice for oil & gas CFOs

    2 | Issue 02

  • s the energy markets continue to evolve, the question of whether to hedge, or not to hedge, continues to

    challenge exploration and production compa-nies (e &Ps).

    Historically, many have argued that e &Ps serve as vehicles for obtaining exposure to energy commodity prices. However, in recent years, industry best practices have evolved and the new consensus is that e &Ps must take their own proactive steps to mitigate risk, in-cluding commodity price risk.

    Theres no question that management teams and investors alike detest the idea of not be-ing able to reap the benefits of high energy prices. And rightfully so. On the other hand, low and/or volatile prices can be one of an e &Ps worst nightmares.

    The key to a successful hedging program is developing and implementing strategies that perform as intended in both high- and low-price environments, as well as in between. That typically means utilizing a combination of instruments, including swaps, put options and collars, among others.

    OverlOOked Aspects

    In our firms daily discussions with companies across the globe, there are several key aspects of hedging that we tend to highlight because they are often overlooked or misunderstood:

    5 The structures of hedges are crucial. There are significant differences, such as basis, credit and operational exposure, in the various hedg-ing structures available to e &Ps differences often overlooked by companies.

    5 so-called exotic hedges, most of which in-volve the selling of options, either direct or indirect, can lead to a disaster if the structures are not completely understood by the manage-ment team.

    5 e &Ps must stress test their hedge portfo-lio so that the performance of both individual hedge positions, as well as the entire portfolio, are well understood in all potential price envi-ronments. These tests should not only include price (market) risk, but basis, credit and op-erational risk as well.

    A

    by Michael corley

    Founder and President of Mercatus energy Advisors LLC

    Issue 02 | 3

  • 155

    135

    115

    95

    75

    55

    35

    16

    14

    12

    10

    8

    6

    2

    4

    $/MMbtu$/BBL

    Apr. 2

    007

    Jun. 200

    7

    Aug

    . 200

    7

    Oct. 2

    007

    Dec

    . 200

    7

    Feb. 200

    8

    Apr. 2

    008

    Jun. 200

    8

    Aug

    . 200

    8

    Oct. 2

    008

    Dec

    . 200

    8

    Feb. 200

    9

    Apr. 2

    009

    Jun. 200

    9

    Aug

    . 200

    9

    Oct. 2

    009

    Dec

    . 200

    9

    Feb. 201

    0

    Apr. 2

    010

    Jun. 201

    0

    Aug

    . 201

    0

    Oct. 2

    010

    Dec

    . 201

    0

    Feb. 201

    1

    Apr. 2

    011

    Data: Mercatus Energy Advisors

    Crude Oil Natural Gas

    OIl & GAs vOlAtIlItY: NYMeX

    HedGInG exAMples

    Swap

    Swap

    Market Price

    Put Option

    Put Option

    Market Price

    Costless Collar

    Costless Collar

    Market Price

    4 | Issue 02

  • 5 Companies should not solely depend on their banks or trading counterparts to provide hedg-ing strategies that are an ideal fit. Banks and trading companies take the opposite side of their customers hedges, which means the bank or trading companys best interest may not align with the best interests of the customer. simply accepting the exact hedging structure suggested by the bank or trading company is rarely in the companys best interest.

    When an e &P decides to develop a hedging program, one of the main challenges is iden-tifying the best types of hedging instruments that will allow the company to meet its busi-ness objectives.

    The first step is determining the companys risk tolerance as well as its hedging goals and objectives. specifically, what is the company seeking to accomplish by implementing hedg-ing program? Is it to reduce cash flow volatil-ity? To guarantee a minimum revenue stream? How much upside is the company willing to give up to reduce or eliminate exposure to low prices and/or volatility? Only after answering these questions, as well as many related ques-tions, should an e &P discuss what hedging instruments to use.

    pItfAlls

    In addition, there are a number of common, hedging mistakes that e &Ps need to avoid at all costs. First, it is crucial to remember

    that hedging should not be considered a source of revenue. A well-designed hedging strategy should provide cash flow and revenue certain-ty, the ability to lock in profit margins and/or protect against declining prices, not to gen-erate profits. If an e &P initiates a hedging program for profit, it has become a speculator.

    The vast majority of hedging mistakes are the result of a poor or nonexistent hedging policy or failing to abide by the policy. Most hedging mistakes can be avoided if the company takes the time and effort to create a proper hedging policy and to develop and implement strate-gies that allow it to meet its hedging goals and objectives.

    e &Ps will be well served to create and imple-ment sound hedging and risk management policies, or review and reassess policies that are already in place, to make certain they are mitigating their exposure to energy price risk (as well as credit, regulatory, operational and basis risk) in todays uncertain economic en-vironment. $

    Michael Corley is veteran energy trader and founder and president of Mercatus Energy Advisors LLC (formerly EnRisk Partners), a Houston-based energy trading and risk man-agement firm. Prior to founding the firm, he held various roles in energy trading, marketing and risk management with El Paso Merchant Energy, Cantor Fitzgerald, and several energy consulting firms. 713.970.1003 MercatusEnergy.com

    It Is crucIal that hedgIng not be consIdered a source of revenue.

    Issue 02 | 5

  • Issue 02 | May 2011

    +12 Other Features A Trio of Top TSX Junior Miners Energy Hedging Tips for CFOsAg Minister Interview Mexico & Montana Momentum New Analyst Investor Scorecard

    Ancient Fuel,New OpportunitiesCoal

    excerpt fromThe Global Commodities ReportIssue 02 | May 2011

    Published by New Vanguard Media Inc.

    www.the-Gcr.com

Recommended

View more >