Hedging Oil Volatility
West Texas Intermediate crude is up more than 60% in 2021 recently breaking the 2014 high. Many traders are speculating that with ESG investments hitting 1.65 trillion in 2020 and the Covid-19 pandemic many companies have reduced their CAPEX. Unfortunately, these lower CAPEX levels appear to be insufficient to deliver the volumes of oil and gas needed to maintain market stability****. This underinvestment in new exploration according to oilprice.com will keep oil prices volatile to moving higher*.
While stock prices usually follow the price of oil the broad energy sector benchmark, Energy Select Sector SPDR ETF (NYSEARCA: XLE) is up in comparison only 48.5% YTD. This puts oil companies trading at less than half their 2014 levels when oil last topped $80 per barrel*.
According to World Oil Magazine, 90% of upstream producers as of Dec 31, 2020, hedged part or all of their production at an average price for a swap in 2021 at $44.69/bbl. The average length of the hedges is estimated at 12 months. **. With WTI spot trading above $80/barrel as of this article, the average hedge is missing out on $35.31/bbl of potential profit ($80/bbl – $44.69/bbl = $35.31/bbl).
The Percentage of Companies that Hedge Their Commodity Risk
Type of Hedges Used
Hedging has been a bit of a double edge sword for oil producers. At first glance, rising oil prices should be a win for upstream companies, however, at the same time, oil producers realize falling oil prices have a devastating effect on their bottom line*. Many Upstream producers went bust when in January of 2020 oil prices fell from the mid-sixties to fourteen dollars a barrel by April. The data suggests that oil companies hedge about 80% of their production**.
The most common hedge used according to World Oil Magazine is a swap. A swap is an agreement with a bank to lock in the price of oil today for a fixed time in the future. This solves the uncertainty of falling oil prices however it comes with the cost of not benefiting from a rise in prices. If oil should rise while their hedge is deployed, they do not benefit from rising prices. This also could explain one of the reasons why the increase in oil prices has not translated to high stock prices.
According to a recent article in Reuters, hedging programs are expensive, analysts said, and producers said investors would rather see them boost production at higher prices than take a chance on additional hedging…. When producers hedge aggressively, they cap profits if prices rally further and increase their costs due to the expensive buying of derivatives. “With every bank saying that oil will be at $90-$100, no one is going to put hedges on right now,” said an executive at a shale oil producer, who agreed to speak on the condition of anonymity. ****
According to data* the Majority of oil companies use 3 other types of hedges for most of the price protection in addition to swaps. The zero-cost collars give the producers an opportunity at zero cost to participate in a limited range which gives them some upside while at the same time limiting their losses. The 3-way options give more upside opportunity than the zero-cost collar however if the market should break through the buffer zone on the downside, losses could be devastating. Several oil producers saw a serve hit to their cash flow, stock price, and dividend using the 3-way options strategy during the 2020 Covid-19 drawdown***.
The 4th most popular hedge, a long put, doesn’t cap the price of oil on the upside however has a negative cost of carrying which simply means oil producers would have to pay considerable capital to hold the hedge.
The Most Common Hedges Used in the Oil Industry
The Ideal Hedge
The search for a reliable hedge that will protect drop-in spot oil prices, not cap the upside and execute the trade at zero cost would be an ideal situation for upstream producers. Another benefit would be if the hedge could be dynamic, in other words, be continually adjusted as spot oil moved higher.
At IPS Strategic Capital our philosophy is that a truly effective hedge should not be dependent on any fundamental, econometric, or technical triggers. In other words, a hedge that is constructed takes absolutely no view on the direction of spot oil and is 100% rules-based.
It is our belief that once a company takes a view on the direction of any particular asset you could be wrong which would create financial hardship. A hedge that is 100% rules-based and systematically implemented with zero to positive carry cost would give producers their cake and eat it too.
The IPS Hedge
The following chart compares how the IPS Strategic Capital proprietary hedge has performed against owning long puts.
The IPS Strategic Hedge vs A Long Put Strategy
The IPS oil hedge does not cap the upside like the swap, collar, and 3-way collar while delivering strong downside protection. If oil should continue to rise the IPS hedge delivers a much lower carry cost or drag, than a long put. Unlike a long put, the trade is implemented for at least a zero cost to credit while dynamically re-striking every 60 days.
IPS Strategic Capital is a quantitative-driven long volatility firm that specializes in building hedge solutions for companies, pensions, endowments, and individuals. It is the goal at IPS to create a mathematical asymmetrical return that is not driven by any view of the markets. If you are interested in learning more about how IPS Strategic Capital can help you implement a long volatility hedging solution for your situation don’t hesitate to reach out.
IPS Strategic Capital designs low-cost hedging strategies that define tomorrow’s risk today. For more information on our strategy solutions please visit our website at investsps.com or call 303-697-3174
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Managing Principal and Chief Investment Officer of IPS Strategic Capital, Dominick Paoloni has served the investment community for over 35 years. Dominick received his Certified Investment Management Analyst (CIMA) through the Wharton School of Business and completed the College for Financial Planning’s CFP certification program.
Dominick is the portfolio manager for IPSAX as well as an Adjunct Professor at the University of Denver, and the University of Colorado Denver, he is a published author in a plethora of financial magazines including an academic white paper published through the Journal or Financial Consultants. Dominick frequently lectures throughout the country and internationally on the real-world use of derivatives in risk-defined money management.
Disclaimer: The information in this article should not be misconstrued as an offer, nor a solicitation, to buy or sell securities. Any past performance of any investment(s) does not necessarily indicate the future performance of any investment(s). No client, current or prospective, should assume the future performance of their investments will be profitable based on historical performance. Any backtest charts and data presented are purely hypothetical and do not represent the performance of accounts managed by IPS Strategic Capital. The results were obtained by applying a rules-based investment process to historical data. All investments have the potential for profit and the potential risk of loss. Changes in investment strategies, contributions, or withdrawals may cause the performance results of one’s portfolio to differ materially from the reported composite performance. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s portfolio. One should always consult an investment advisor before making any investment decisions.
One should always consult an investment advisor before making any investment decisions as well as consider the investment’s objectives, risks, charges, and expenses carefully before investing or sending money. This and other important information about the Strategy is available upon request.
Please click here to read our Disclosure Notice.
*Editor OilPrice.com: U.S. Oil Stocks Are Seriously Undervalued Right Now
Fri, October 15, 2021, 4:00 PM
**World Oil: Oil and gas companies hedging production farther into the future
By Shane Randolph, Josh Schulte, and Jeff Nicholson on 4/26/2021
***Oil & Gas: Oil and Gas Investment in the New Risk Environment
By Joseph McMonigle, Alan Thomson, Christof van Agt, Rebecca Fitz, and Jamie Webster on 12/10/2020
****Reuters: U.S. shale firms hesitate to hedge more, despite the surge in oil prices
By Devika Krishna Kumar July 7, 2021
One should always consult an investment advisor before making any investment decisions as well as consider the investment’s objectives, risks, charges, and expenses carefully before investing or sending money. This and other important information about the Strategy are available upon request.
One should always consult an investment advisor before making any investment decisions as well as consider the investment’s objectives, risks, charges, and expenses carefully before investing or sending money. This and other important information about the Strategy is available upon request.
Please click here to read our Disclosure Notice.
