Is Herd Mentality Driving Commodity Hedging?
September 18, 2020
Dominick Paoloni, CIMA®
CIO & Founder
Portfolio Manager, IPSAX
Adjunct Professor, University of Denver
& University of Colorado
I recently read an article detailing how European airlines lost $4.66 Billion* last year through poorly managed fuel hedges. As a hedging practitioner who teaches commodity and financial markets hedging at the University of Colorado in Denver, I found this to be a textbook example for explaining to my students why the hedges used by many companies are poorly placed and potentially dangerous.
If the hedge used by the European airlines had been recommended by one of my students in a school project, they would have received a subpar grade. So how could a cartel of professionally managed airlines relying upon supposedly expert hedging advice have experienced such disastrous losses to the airlines and their shareholders? I believe the explanation to be herd mentality, rather than sound analysis and effective hedging.
Unlike the capital equity markets, which rely on diversification to manage risk, the commodity industry’s main tool for managing commodity price risk is hedging. According to the US Energy information bureau, the most common hedges utilized by oil and gas companies are swaps followed by two-way collars, three-way collars, swaptions, and protective puts.
According to Opportune, as of December 31, 2019, 70% of surveyed companies had crude hedges in place and 60% had gas hedges in place.
Analysts at Goldman Sachs estimated that, as of September 2020, roughly 66% of crude production was hedged at an average price of 36.99/barrel*.
As of Dec 31, West Texas Intermediate crude was trading at 48.42/barrel, which means the average oil company hedging with a swap or two-way collar was losing $11.43/barrel ($36.99 – $48.42 – = -$11.43).
Upstream companies that produce commodities regularly hedge to protect their price by selling swaps or implementing two-way collars. In 2020, according to Goldman Sachs, US oil companies sold swaps and collars at an average price of $36.99/barrel. Thanks to hedging, when oil hit a low of $13/barrel on April 27, 2020, the average oil company was making $23.99/barrel ($36.99 – $13 = +$23.99) on their swap or collar.
A swap is a private contract between two parties for a specific time and price. If an oil producer wants to protect their price, they will sell a swap to the counterparty, who will buy a swap. As swaps are over-the-counter transactions, it is important to understand that there could be default or liquidity risk. A two-way collar uses options, which could be either OTC or exchange-traded. As with a swap, two-way collars protect the downside at the cost of capping the upside at or near the price the trade was executed. An oil company may choose not to hedge if their analysts believe oil prices will rise, as a swap or two-way collar would result in a loss as prices rise. In contrast, the three-way collar will give some upside to a cap but introduces risk if oil drops lower than the short put position. A swaption and protective put have hard costs that oil and gas companies may choose not to pay, especially if they are hedging 100%.
To Hedge or Not to Hedge
Albert Einstein once said, “True genius is applying imagination to knowledge.”
What if we can put on a hedge that will benefit when oil prices rise AND benefit when oil prices fall? Many hedges tend to be very binary, meaning that it may protect against the downside, but cap upside opportunity? Let’s see if we can use a combination of hedges to be more flexible and effective as conditions change. In the end, as I tell my students, the best hedge is always a winner no matter what happens.
Let’s look at one of the IPS Strategic Capitals hedge concepts. The basic setup would be to let 1/3 of the price of an oil companies flow float with the market. In other words, just receive spot price on 1/3 of the oil revenues. The next step is to tie 1/3 of the oil revenues to short oil futures contracts. Selling a swap or collar would also work in this case, but for the sake of this article, we will use a standardized contract to illustrate the payoff. The final step would be to tie 1/3 of the revenue stream to a long-put option on oil futures contracts.
There is a premium cost for the long put, however, this premium will only apply to 1/3 of the oil revenues. (see Chart)
This setup mathematically puts the upstream oil or gas company in a winning position, regardless if the market should move higher or lower.
Let us break it down. If oil prices should drop, the producer will be making less on 1/3 of their oil revenues, which will be floating with the market. That is still much better than making less on 100% of the revenue stream, especially as Goldman said 33% of oil companies don’t hedge at all.
Next, let’s examine what’s happening with the remaining 2/3 of the cash flow. If prices drop, the short oil futures and the puts will be profitable, holding the value on 2/3 of the cash flow. (see Chart)
If oil prices should rise, the situation looks even better. The floating portion of the cash flow will appreciate on the spot market, as will the portion tied to the long-put option on the futures contract. Put option premium will only be lost on 1/3 of the position.
This strategy will result in positive cash flow on 2/3 of the position, with unlimited upside, and the 1/3 short futures contract position will have locked in the original lower price. This is much preferable to being short futures contracts, in a swap or two-way collar on 100% of the cash flow, a practice employed by 66% of oil companies on average. These companies will have entirely squandered the opportunity to benefit from any price appreciation.
Determining where and how the positions should be placed and rolled is where a professional will be value added. Unfortunately, despite the clear value of effective hedging, most advisors have not had the opportunity to adequately learn this specialized skill. This is understandable, but to best serve our clients, it would be very advantageous for the advisory community to recognize that proper hedging is an essential element of money management. Whether it be IPS or another firm with demonstrated expertise in hedging, working with a specialist to take advantage of the dramatic benefits of effective hedging could save a corporation billions.
Putting the Strategy into Practice
Let us see how this strategy works in practice. For this example, to make the math easy, we are going to assume that an oil company is extracting 30,000 barrels per quarter. So, on December 30, 2019, West Texas Intermediate crude was trading at $63.05/barrel. They were paid $63.05 price X on 30,000 barrels =$1,891,500 for the quarter.
Seventy percent of Oil companies were using some type of hedging going into 2020.
||$63.05 X 30,000
|March 31st, 2020
||20.34 X 30,000
|June 29th, 2020
||40.65 X 30,000
|Sept 30th, 2020
||38.72 X 30,000
|December 31st, 2020
||48.50 X 30,000
So, in Scenario 1, we will assume the oil company does nothing. The analysis believes oil is going higher and using a swap or two-way collar will prevent the company from benefiting from price appreciation They let the market float and receives quarterly revenues based on the spot price of WTI.
The total revenues received through 2020 based on 30000 barrels quarter was $6,337,800
In scenario 2, we will assume the oil company uses Swaps or Collars through-out the Year. We will use the average price according to Goldman, Sachs of $36.99/barrel.
$36.99/barrel X 30,000 = 1,109,700 X 5 payout from Dec 2019 through Dec2020, the total revenues received through-out the year = $5,548,500
In Scenario 3, we will use a combination of options and futures as defined above.
||10 put option
||Put option Expiration
||Put Value@End of Qtr.
||10 Short Futures
||Futures Value @ Delivery
|Dec 30th, 2019
||16 April 20
||21 April 20
|March 31st, 2020
||16 July 20
||21 July 20
|June 30th, 2020
||15 Oct 20
||20 Oct 20
||20 Jan 21
||20 Jan 21
|December 31st, 2020
||15 April 21
||20 April 21
$63.05 X 30,000 Barrels = $1,891,500 – $37,150 (cost of 10 put) = $1,854,350
$20.34 X 10,000 Barrels = $200,340 (Float)
$20.34 X 10,000 Barrels = $200,340+ $377,430.50 (net profit) = $577,770.50 – $52,250 cost of option (option P/L) =$525,520.50
$20.34 X 10,000 Barrels = $200,340 + $400.290 (60.58 -20.29*) X 10000 = $600,630 (futures P/L)
$200,340 + $525,520.50 + $600,630 = $1,326,490.50
*21 April 20 futures value on March 31st, 2020
June 29th, 2020
$40.65 X 10,000 Barrels = $406,500 (Float)
$40.65 X 10,000 Barrels = $406,500 + (+$210) = $406,710 – $38,650 cost of Options (option P/L) =$355,630
$40.65 X 10,000 Barrels = $406,500 – (29.54 – 39.38) = $308,100 (futures P/L)
$406,500 + $355,630 + $308,100 = $1,070,230
Sept 30th, 2020
$38.72 X 10000 Barrels = $387,200 (Float)
$38.72 X 10000 Barrels = $387,200 + (+ $980 closing option) = $388,180 – (cost of option $32,550) (options P/L) = $355,630
$35.69 X 1000 Barrels = $387,200 – (39.70 -39.78) = $386,400 (futures P/L)
$387,200 + $355,630 + $386,400 = $1,129,230
December 31st, 2020
$48.50 X 10000 Barrels = $485,000
$48.50 X 10000 Barrels = $485,000 – (+ $85) = $485,085 – (Cost of Option $39,650) (Options P/L) = $445,435
48.50 X 10000 Barrels =$485,000 – (40.84 -48.40) = $409,400 (Futures P/L)
$485,000 + $445,435 + $409,400 = $1,339,835
Scenario 1, which used 100% floating market returned =$6,337,800
Scenario 2, which used 100% fixed rate market returned = $5,548,500
Scenario 3, used a combination of fixed, floating and options = $6,720,135
The combination strategy returned a $382,335 gain over the floating market or 6.03% over the year while the combination strategy outperformed the fixed strategy by $1,171,635 or 21.11% over the year.
The question that must be asked is why commodity companies are not asking their advisors to build hedges that allow companies to protect their downside while giving the companies an upside opportunity? After 30 plus years as a risk manager, I have evolved to the core belief that using properly placed optionality in a low-cost efficient way is the best to manage risk.
IPS Strategic Capital is a Quant firm that builds hedge solutions for corporations, endowments, pensions, advisors, and individual clients. For other hedging strategies or custom hedging solutions please contact IPS Strategic Capital (Investps.com) 303-697-3174
Dominick Paoloni, CIMA is a member of the OIC Advisory Council and the TD Ameritrade Trading Panel. Mr. Paoloni guides future professionals as an Adjunct Professor at the University of Denver and the University of Colorado. He is a published author and is frequently quoted in financial journals and can be reached at email@example.com
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