Dynamic Hedging Strategies

Hedge it, and forget it? A passive approach to hedging production may have been the norm in days gone by, but producers who fail to dynamically manage their hedge portfolios in the current market environment are leaving money on the table and accepting unnecessary risks.

Just 20 years ago, a small minority of producers hedged oil and gas price risk. Today, most producers hedge a portion of their production to address cash-flow concerns or lock in opportunities. Basic hedging instruments such as fixed-price swaps, puts and calls are popular tools for managing risk because they are effective, liquid, transparent and simpler to communicate to a broad group of stakeholders. And hedging products are expanding to address location-based risk, the increased production of liquids, and transport optimization.

Yet many producers are not getting optimal value from hedging, because they are not actively managing the hedge portfolio to fully exploit their financial and operating leverage. A dynamic approach also mitigates price and liquidity risk and maximizes upside participation.

The more traditional, passive approach to hedging, whereby the producer sells a swap and holds the position for the life of the transaction, has significant limitations and inherent risks. The limitations include missed opportunities to more fully participate in favorable price moves. The risks include lower operating margins and diminished liquidity.

Fixed price swaps and price collars offer price stability, but also introduce limits on the upside that comes from price appreciation. In a period of rising prices, this upside constraint can drain liquidity and/or reduce access to capital.

For example, large-cap producers may sell futures or execute swaps with collateral terms. When prices rise above the sold futures price or collateral threshold for a swap, the producer must post cash margin equal to the difference between the market price and either the futures price or swap collateral level.

The need to use cash to meet margin calls rather than deploying that cash to drill the next cash-flow-generating well is at best a competitive disadvantage and in some cases catastrophic. It is certainly a value destroyer. There are numerous examples of producers who needed to sell assets or raise debt to unwind hedge positions, resulting in weaker balance sheets, diminished cash flow or both.

Secured reserve-based borrowers are not immune to this risk. On day one, fixed-price swaps maximize the borrowing base. This can be very attractive to growth-oriented producers seeking to maximize debt capacity. In a falling price environment, these hedge positions can help maintain a higher borrowing base.

However, in a rising price environment, the opposite is true. Low-priced hedges can lead to a lower borrowing base in situations where existing hedges are priced below lender price decks. This is a real concern, given that borrowing bases are typically redetermined every six months. Active hedge management seeks to minimize risk by continually analyzing implied option volatility, option skew and time spreads for opportunities to de-risk the hedge portfolio via basic instruments such as swaps, puts and calls.

High oil, low gas

In this high-oil, low-gas price environment, there are plenty of opportunities for producers to improve their risk profiles through active hedging portfolio management. What can be done now? One answer is new hedges, particularly in crude oil and liquids, since current values are far above most producers' targets for earnings performance.

Calendar-year 2012 and 2013 West Texas Intermediate (WTI) swaps recently traded above $100 per barrel with the forward curve in slight contango (i.e., priced above the expected spot price at maturity). A return to these levels would provide producers with an opportunity to add new hedges. (In all cases, producers should stop to look at their hedge target range–the amount of production they've previously decided to hedge–to make sure additional hedges won't exceed the upper bounds of the range.)

There are premiums on put options in the current market, making a producer "three-way collar" an attractive hedging tool. In this structure the producer buys a put near the current swap price and sells both a put and a call much further away from the current market to finance the purchased put premium.

Here's an example, based on recent prices: The swap for 2012 WTI is $100 per barrel. A $95/$75/$117 producer three-way could be executed costless.

• With the market settling above $117, the producer would receive $117.
• 
  
• Between $95 and $117, the producer would receive market.
• 
  
• Between $75 and $95, the producer would receive $95.
• 
  
• Below $75, the producer would receive market plus $20.
• 
  
• So, at $65, the producer would receive $85.

In our view, producers tend to "overpay" for put options, either as stand-alone price floors or as part of a price collar. A purchased put protects the producer if prices fall to zero, an unlikely occurrence. And crude put options generally trade at a higher implied volatility relative to similarly out-of-the-money call options. In effect, the producer is both overpaying for protection and buying more protection than necessary. Instead, purchasing a put spread allows the producer to buy the necessary amount of price protection at the most economic cost.

Timing risk

One of the risks of a passive hedging approach is timing risk. This involves the mismatch between the pricing of a hedge instrument and the underlying physical commodity.

An oil and gas concern physically produces a daily long position in crude and natural gas, which is priced daily and with a monthly index, respectively. The timing risk arises when the producer picks a point in time to execute an offsetting short position covering production volumes for one to three years, or more.

The decision to execute the short position will be based on a number of factors, including market view, timing of asset acquisitions and commitment to drilling programs. A passive approach to managing the hedge portfolio may leave the producer susceptible to margin squeeze and limit future access to capital necessary to accelerate the development of reserves.

For example, in the summer of 2008, when oil was heading to $147 per barrel and natural gas was over $14 per thousand cubic feet, operating costs were rising significantly as well, albeit at a slower rate. Producers who locked in fixed-price swaps or collars at lower price levels started to experience significant cash-margin squeeze as upside price appreciation was capped, while operating costs continued to rise.

Producers who actively managed their positions using option strategies were able to reap the benefits of an expansion in operating margins by realizing the higher prices. The inherent operating leverage in producing oil and gas reserves allowed these producers to achieve higher IRRs and maintain access to capital at more attractive rates.

In today's low-price environment, an incremental $.50 per thousand cubic feet price realization can mean the difference between break-even—or even a cash loss—versus an acceptable return that continues to generate cash flow and attract capital.

Current natural gas prices are significantly below previously executed swap levels for many producers. What if that changes, however? One solution is a "consumer collar" to the hedge. The producer would sell a lower put and use those proceeds to buy a call at the level of the initial swap.

Recently, a producer could have executed the following: With an initial hedge in place for 2012 at $6, a producer could currently sell a $4 put and use those proceeds to buy a $6 call, effectively removing the cap and opening upside participation.

• With the market settling above $6, the producer now receives market.
• 
  
• Between $4 and $6, the producer receives $6.
• 
  
• Below $4, the producer gets market plus $2.

So, at $3.75, the producer receives $5.75.

Removing the upside encumbrance eliminates all margin risk and expands the volume available to hedge upon a recovery in prices. The producer now has a protective spread in place, but the protection is limited to the difference between the initial sold swap and the sold put. This is a particularly effective strategy for a producer that is in growth mode.

A dynamic approach to managing risk considers the dual objective of maximizing downside protection while de-risking the upside constraint. Risk tolerance, asset mix, operating metrics, capital structure and market outlook should all be taken into consideration. The decision to hedge and how to hedge is not only about protecting realized revenue. Hedging has a significant impact on operating cash flow, liquidity and access to capital. Actively managed, a hedge portfolio can create incremental enterprise value, operationally flexibility and access to liquidity.

Christopher Lang, senior vice president, Asset Risk Management LLC (ARM), Houston, has more than 20 years of energy industry experience, the past 18 focused on providing risk management services. He can be reached at 847-920-5199 or mailto:clang@asset-risk.com.