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.1 This underinvestment in new exploration according to oilprice.com will keep oil prices volatile to move higher.2
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.2
According to World Oil Magazine, 90% of upstream producers as of Dec 31, 2020, hedged part, or all 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.2 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.2 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.3
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.1
According to data2, most 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.4
The 4th most popular hedge, a long put, doesn’t cap the price of oil on the upside however has a negative cost of carry 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 Mexican government is one of the largest users of puts to hedge their upstream production. Raul Gonzales of the Mexican finance ministry has stated “The oil hedging program is necessary. It offers stability amid public finance and budget challenges. It’s expensive but has generated benefits, it prevents the country from losing its investment-grade rating and guarantees solvency.” The carry cost is estimated that Mexico spends about 1 billion dollars annually.4
The Ideal Hedge
The search for a reliable hedge that will protect a drop-in spot oil price, 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 effect 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 chart above shows just how the IPS proprietary hedge compares to West Texas Intermediate spot crude from 2006 to the present day. Our proprietary hedge is executed at a zero cost and rolled every sixty days. The benefit of rolling this hedge allows the upstream producer to continue to raise the hedge as oil climbs higher at zero cost while benefitting from higher prices.
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
In light of the fact that long puts have a greater carry cost, the IPS hedge has shown to out-perform the put strategy over the period examined. The data supports the IPS hedge would have been a far better strategy compared to the most common hedges used in the industry.
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
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.
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Works Cited Page
1Reuters: U.S. shale firms hesitate to hedge more, despite a surge in oil prices by Devika Krishna Kumar July 7, 2021
2Editor OilPrice.com: U.S. Oil Stocks Are Seriously Undervalued Right Now Fri, October 15, 2021, 4:00 PM
3World Oil: Oil and gas companies hedging production farther into the future by Shane Randolph, Josh Schulte, and Jeff Nicholson on 4/26/2021
4Oil & 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
Is Herd Mentality Driving Commodity Hedging?
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, wh
ich 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, and the company would have been paid $63.05 price X on 30,000 barrels =$1,891,500 for the quarter. As 70% of oil companies were using some type hedging going into 2020, we can assume that this example is representative of the 30% who were simply receiving the spot.
|Dec 30th,2019||$63.05 X 30,000||$1,891,500|
|March 31st, 2020||20.34 X 30,000||$610,200|
|June 29th, 2020||40.65 X 30,000||$1,219,500|
|Sept 30th, 2020||38.72 X 30,000||$1,161,600|
|December 31st, 2020||48.50 X 30,000||$1,455,000|
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.
|Date||WTI Spot||10 put option||Strike||Put option Expiration||Put Value@End of Qtr.||10 Short Futures||Futures Expiration||Futures Value @ Delivery||Revenues|
|Dec 30th, 2019||$63.05||$37,150||61.5||16 April 20||$377,430.50||-60.58||21 April 20||20.29||$1,854,350|
|March 31st, 2020||$20.34||$52,250||29.5||16 July 20||$210||-29.54||21 July 20||39.38||$1,326,490|
|June 30th, 2020||$40.65||$38,650||39||15 Oct 20||$980||-39.70||20 Oct 20||39.88||$1,070,230|
|Sept 30th,2020||$38.72||32,550||40||20 Jan 21||$85||-40.84||20 Jan 21||48.40||$1,129,230|
|December 31st, 2020||$48.50||39,650||48||15 April 21||n/a||-48.59||20 April 21||n/a||$1,339,835|
$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 29, 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 30, 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 31, 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 firstname.lastname@example.org
The information on this website should not be misconstrued as an offer to buy or sell, or a solicitation to buy or sell securities. With any investment, past performance is not necessarily indicative of future performance.
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.