To Hedge Or Not To Hedge That Is The Question
By Mike Byfield, Daily Oil Bulletin
This year, many petroleum producers have had the daunting duty of reporting hefty hedging expenses to their shareholders. Given market fundamentals that appear beneficial to the energy sector, is it time to abandon commodity price protection?
Tim Simard , a senior principal with Calgary-based RiskAdvisory, says consistency and education are the keys to sound hedging programs. His consulting practice is dedicated to helping producers design appropriate hedging policies.
There's an old saying among traders the market likes to take everyone out at the knees, Simard warns. He outlines why many producers get themselves hurt at both ends of the commodity price cycle:
- An unprotected producer suffers a painful revenue decline when oil and gas prices move downward.
- Once stung, the producer adopts commodity price protection through a hedge program. The company must report the negative financial impact of those contracts when oil and gas prices rise.
- Stung again, the producer refuses to renew its hedging contracts, thus positioning itself for another revenue loss when commodity prices eventually drop.
Of course, how that plays out in the real world depends a lot on the duration of commodity price cycles which are notoriously hard to pin down and nearly impossible to time correctly.
In Simard's experience, refusing to hedge any oil and gas production may make good sense for a particular company. If hedging is implemented, however, the strategy should be professionally designed and normally remain in place throughout the business cycle with disciplined consistency.
Canadian oilmen are very competent businessmen that's how they've been able to create billions in value for their investors -- but few of them have much expertise in futures trading, comments Simard, a former vice-chairman of Bankers Trust Canada.
With almost two decades of managing risk, he stresses that the stated objective of most producer hedging is to reduce the impacts of commodity price volatility and thus stabilize corporate cash flow. But many oil and gas managers confuse that function by injecting their own views on future price movements into their hedging decisions.
If a personal price view does become included in a hedging strategy, Simard suggests that the program's objective can mutate -- consciously or unconsciously -- into attempts to make money on hedge positions.
Isn't injecting your view [into hedging decisions] akin to speculation? the RiskAdvisory specialist asks his customers, whose professional training typically focuses on engineering, geology and accounting. Do you think that you have a competitive advantage compared to the market in your ability to forecast commodity prices?
He does not rule out the possibility that petroleum managers may actually have superior pricing insight in some niche situations, like a regional NGL market. But overall, he doubts the capacity of non-professional oilpatchers to consistently beat the trading pros.
Simard warns that brokerage financial analysts, far from helping, tend to exacerbate the problem.
I have rarely if ever seen an analyst criticize a producer for revenue losses sustained because price protection was not in place when commodity prices drop, he comments.
On the other hand, some analysts and many investors do complain when hedging costs are sustained during an upward swing of commodity prices. And that tendency to complain is reinforced by accounting rules.
Each quarter, a company must report the future impact of its current hedging position over the life of its current contracts, calculated on the assumption that current prices will remain constant over the life of those contracts.
This is a purely paper exercise, of course, since commodity prices will vary. Leaving out the speculative element, Simard stresses that there is in reality no true financial cost other than the hedge fee itself.
As an example of a legitimate use of hedges, the risk analyst notes that privately-held producers who do not have to worry nearly as much about investor moods -- have been known to hedge virtually all of their production. In this way, they can safely employ a much higher debt-to-cash flow ratio while remaining financially sound.
Simard says publicly-traded petroleum producers in Canada have learned to keep debt levels very low as their basic strategy for dealing with commodity price volatility.
His perspective on cash flow stability versus commodity price speculation, while technically correct, makes cold comfort for the manager whose hedging strategy has reduced his company's current revenue by many millions.
One executive, who prefers to go unnamed, feelingly recalls being treated like a leper by the rest of the management team when his hedging program decreased the firm's annual revenue by almost $30 million.
Even Gwyn Morgan , president of the highly successful EnCana Corporation , found himself on the defensive at this year's annual meeting, observing sharply that no one can reliably predict commodity prices. Petro-Canada has cut back its hedging activity, reducing the risk of both commodity price speculation and investor criticism.
Simard notes that hedge dealers themselves are exceedingly careful about balancing their own exposure to market risks.
For example, if a petroleum producer forfeits $20 million due to hedging, the company that wrote the hedging contract is unlikely to earn anything like $20 million. Within a day or two of writing that contract, the dealer most often will have eliminated the market risk to itself through countervailing contracts, Simard explains. If dealers do retain speculative market positions, the risk and the profit of those positions is closely tracked, a task which producers often overlook.
Hedge dealers make their money primarily through earning a small risk fee on each transaction, not by massive speculative gambling on commodity values. The going rate to price-protect a barrel of crude oil for a year is currently estimated at less than a nickel.
Simard reports that his utility clients are under pressure from regulators to maintain disciplined hedge strategies. With the potential for painful prudence reviews of their hedging programs, he says, they have spent a great deal of time and effort formulating consistent hedge strategies that have garnered the support of their stakeholders.
Like utilities, Simard advises, the oil and gas community should educate managers and shareholders about the operational role of these financial instruments.
In particular, he counsels managers to report significant shifts in hedging policies and positions immediately, eliminating potentially unpleasant surprises for investors. If a price view component is to be maintained in the hedge program, the effect of these decisions should be tracked through time. If it is not contributing value, the price view component should be eliminated.