Strategic Hedging
A holistic approach can rein within the overall risk-reward proposition for investors, employees and management.
The vast majority of commodity-price hedging by small, and 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.
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Secured-debt investors include the only participants that appear genuinely enthusiastic about hedging; however, as they often are commercial banks which might be bundling hedging services with loans, it is 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 strategy we characterize as “strategic hedging”.
Roots in agriculture
Price hedging techniques and methods emanated from the agricultural markets. Farmers wished to lock in price certainty over a portion of their crop during planting in an attempt to avoid financial ruin from adverse price movement at the time of harvest. The time period of the forward activities was governed by the duration of the summer season, resulting in contracts typically which range from three months to one year.
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For the reason that farmer could alter his decisions on crop allocation each and every season, the amount of the hedge naturally matched the use of the commitment period. Thus, hedging implementation practices evolved that focused totally 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 also 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 growth of agricultural futures exchanges. Notably, though, the strategies for designing and implementing hedging policies, which were molded in the agricultural futures pits in Chicago, just weren't substantially altered. Today, precisely the same methodologies are employed in the finance and treasury departments of E&Ps as well as on the desks from the commodity trading departments of commercial and investment banks as were developed and honed within the agricultural commodity markets of yesteryear.
The normal method is to start at time zero (now) and move forward in time, estimating the quantity of production and the most closely correlated standardized contract. Since the futures markets’ liquidity tends 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, for example, would be to estimate monthly production volumes for 12 to A couple of years at the most, and then to decide on the best contracts to hedge some of that volume. Within the agricultural arena, the place that the duration of a project (i.e. some time from planting to reap) is limited, this technique can effectively and dramatically reduce financial risk. Unfortunately, from the energy production arena, project duration is measured in a long time and sometimes decades, not in months or seasons.
Earnings versus value
Since the duration of production greatly exceeds the scope in the typical hedging program, most contemporary commodity-price hedging programs are just locking in a small part of future cash flows. The web present value of the sum total of all future expected cash flows therefore is confronted with unmitigated future price volatility. Assuming the average North American E&P company comes with an eight-year R/P (reserve-to-production) life, even if 100% of production is hedged to the first two years, then below 30% of the value of the assets is hedged, even considering intrinsic declines in production.
From a fundamental equity investor’s perspective, the benefits of a conventional hedging program are in most a slightly lower probability 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 wonder that managements of E&P organizations 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 coming in at Libor plus 100 to 300 basis points. In comparison with unsecured mezzanine debt at approximately 18% and personal equity at 25%, secured debt is extremely inexpensive, and thus, widely sought after. The most commonly used vehicle for accessing secured debts are the syndicated bank-borrowing- base facility, a revolving loan with a two- to three-year term best known in the industry as an “RBL” or reserve-backed loan. These refinancing options use an independent third-party engineering report, with the bank’s own assessment of future pricing, to guage the “base” amount of the borrowed funds facility. Generic terms will be the lesser of either 50% of P1 (total proved reserves) or approximately 65% of PDP (proved, developed and producing reserves), by using a price deck of approximately 70% of the forward Nymex curve.
As an example, a company desiring a secured loan against an E&P asset owning an engineering report demonstrating a PV-10 (the actual value of future cash flows at the standardized 10% discount rate) of $100 million on PDP reserves employing a conservative 70% forward pricing curve, should be expecting to be awarded a $65-million credit line. These loans have various customary restrictive covenants. Most significantly, however, the base amount is “reset” periodically (typically each), adjusting for asset acquisitions and divestitures, the long run quantity and cost of reserves, and pricing-deck assumptions. Because of the extreme volatility of energy commodity prices, usually the latter impacts the calculation most dramatically, both with an absolute basis and coming from a surprise/uncertainty perspective.
In our example, when 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 can be reset to $39 million. The business would then have to pay back the $26-million contrast between the original $65-million RBL and the adjusted $39-million RBL. This is problematic if the company does not have sufficient operational liquidity at the time of reset, forcing the issuance of high-cost mezzanine debt or equity. In periods of unstable real estate markets, the only other options are asset sales, corporate sale or bankruptcy.
Commercial banks and investors that loan funds on a secured basis are not investors in your company. Despite every one of the friendliness and fanfare shown from your relationship banker, its only job when originating or doing a borrowing-base facility is usually to ensure that it loans capital on an almost risk-free basis. That’s why the pace is priced in numerous basis points above Libor, the pace at which banks lend money to one another on a short-term basis.
The bank’s security is in keeping the actual time period of the loan short (six-month resets) as well as in making sure there are enough assets backing its capital so that should those assets must be liquidated, it would recover 100 cents around the dollar loaned. Each time a bank encourages an organization to hedge, generally simply because it increases its fee. Unless it really is reducing its rate or increasing the RBL borrowing-base calculation formula to take into account 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 prevent triggering a cash-flow-related loan covenant for a while. However, given that even a generic RBL has value-related covenants (debt-to-capital; debt-to-equity) de- signed to shield against balance-sheet (not cash-flow) insolvency, the safety is minimal at the best. When a company employs a RBL to capture the advantages of a lower blended tariff of capital, it is shouldering additional commodity-price-liquidity risk. Unless the complete value of the RBL continues to be 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 price of adding commodity- price insurance for that total balance of the RBF versus the substitution expense of unsecured mezzanine debt. Commodity-price insurance policies are available in the form of premiums purchased put options. Many managements would think this can be outrageously expensive being a benchmark, consider the approximate 18% expense of capital demanded by unsecured lenders. These unsecured lenders, as opposed to the secured RBL syndicate, are investors in your company. Since their investment just isn't completely covered by the nominal liquidation from the assets of the company, they've got a true stake and alignment inside the management of those assets for future growth and price.
In other words, an unsecured, preferential investor in naked E&P assets requires a hurdle return of 18% and a private-equity investor demands 25%. Any funds which come below those rates are not bearing any true operational, fundamental or commodity-price risk. Service repair shop that uses low-nominal-cost, secured RBL financing should know that it is materially increasing the likelihood of distress and bankruptcy due to the true investors. The buying price of that increased risk is explicit since the difference between the price of financing only using unsecured mezzanine debt and also the price of financing utilizing a RBL that has been fully hedged using energy price puts. A company can also shift that risk to third parties by using swaps, forwards and collars- i.e. by increasing its hedging program to hide the total value of the RBL. While forward sales and other tools do not have a sudden income-statement impact, as compared to the cost of premium paid on commodity-price put options, the corporation has given up significant operational and strategic flexibility and thus, has chosen to deal with as significant a cost as the explicit expense of put-option premium.
Introducing strategic hedging
Both the basic elements in the strategic hedging program are: 1) understanding that hedging is about minimizing the risk associated with major decision-making, and a couple of) that hedging is most properly viewed in the context of the cost of capital, less a line-item cost around the income statement.
Going back to the roots of commodity-price hedging, the farmer’s goal has not been to smooth seasonal cashflow, but rather to make sure that the logical strategic decision he earned to plant crop x, that was based on all of the information he'd access to at the time of planting, failed to result in financial disaster after the harvest solely because prices had changed. Likewise, when an E&P firm helps to make the strategic decision to formulate and produce an oil and gas field, or to purchase or merge with a competitor, it can only take into consideration the price environment that exists during the time of investment. A strategic hedging plan would con- sider the total duration of production and also the value of being able to adhere to an initial plan no matter unpredictable short-term price volatility.
Management teams that employ conventional hedging methods often complain in the insurmountable cost of put options, or opportunity costs of swaps and forwards. They must move away from a myopic target the income statement and put those costs while the income statement, cash-flow statement and balance sheet; that is certainly, they need to understand how hedging may affect their tariff of capital.
Surprising as it can seem, ExxonMobil is an active strategic hedger despite the fact that it does not use any commodity-price derivatives. ExxonMobil plans and executes its strategy with plenty of liquidity and flexibility to totally ignore short-term commodity-price volatility. Exxon also chooses to take care of a strong liquidity position and doesn't rely on secured debt because the primary financing mechanism underlying its business design. The relatively 'abnormal' amounts of net debt carried from the company are not accidental, but alternatively a strategic decision.
Strategic hedging is approximately 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 developed into a tool for smoothing quarterly results along with a major profit center for your secured lenders.
Meanwhile, companies that follow conventional “conservative” policies often find themselves on the brink of distress, insolvency, liquidation and bankruptcy when their bank syndicate makes its semi-annual capital call. Financial management is frequently an afterthought at operationally focused E&P companies. Management will be well advised to invest the identical effort in engineering the protection and soundness of its capital structure mainly because it does in the coal and oil fields that compose its assets.
