A holistic approach can rein within the overall risk-reward proposition for investors, employees and management.
The vast majority of commodity-price hedging by smaller than average midsized exploration and production companies is strategically ineffective. Equity investors typically express ambivalence about hedging policy, and management teams often express frustration with both the process and results.
Secured-debt investors would be the only participants that seem genuinely enthusiastic about hedging; however, while they often are commercial banks which are bundling hedging services with loans, it's not obvious whether their enthusiasm is driven by improved risk management or by additional fee capture.
The time is right for the industry to abandon myopic, tactical approaches and embrace an all-natural perspective on managing commodity price risk, a method we characterize as “strategic hedging”.
Roots in agriculture
Price hedging methods and techniques emanated from the agricultural markets. Farmers wished to lock in price certainty on a portion of their crop during planting in an attempt to avoid financial ruin from adverse price movement before harvest. The duration of the forward activities was governed by the duration of 4 seasons, resulting in contracts typically ranging from three months to one year.
For the reason that farmer could alter his decisions on crop allocation each and every season, the time period of the hedge naturally matched the amount of the commitment period. Thus, hedging implementation practices evolved that focused totally on basis risk (the gap between the actual product price as well as the standardized product price) and quantity.
Falling market share of oligopolistic oil trusts and the deregulation of natural gas markets inside the latter half of the twentieth century increased the realized volatility in energy commodity prices. Markets for standardized energy contracts emerged, mimicking the expansion of agricultural futures exchanges. Notably, though, particularly for designing and implementing hedging policies, that had been molded in the agricultural futures pits in Chicago, weren't substantially altered. Today, exactly the same methodologies are employed in the finance and treasury departments of E&Ps and on the desks of the commodity trading departments of commercial and investment banks as were developed and honed inside the agricultural commodity markets of yesteryear.
The common method is to start sometimes zero (now) and advance in time, estimating the quantity of production and the most closely correlated standardized contract. As the futures markets’ liquidity tends to decrease the farther one moves into the future from time zero, the bulk of planning and implementation is dependant on the near term.
Common practice, for instance, would be to estimate monthly production volumes for 12 to Two years at the most, and then to select the best contracts to hedge part of that volume. Inside the agricultural arena, where the duration of a project (i.e. enough time from planting to harvest) is limited, this technique can effectively and dramatically reduce financial risk. Unfortunately, inside the energy production arena, project duration is measured in a long time and sometimes decades, not in months or seasons.
Income versus value
Since the duration of production greatly exceeds the scope of the typical hedging program, most advanced commodity-price hedging programs are just locking in a small area of future cash flows. The net present value of the sum total of all future expected cash flows therefore is confronted with unmitigated future price volatility. Assuming the common North American E&P company comes with an eight-year R/P (reserve-to-production) life, even if 100% of production is hedged for the first two years, then less than 30% of the value of the assets is hedged, even considering intrinsic declines being produced.
From a fundamental equity investor’s perspective, the advantages of a conventional hedging program are near most a slightly lower chance of bankruptcy during the covered period. Considering the fact that many equity investors use E&P stocks as proxies for commodity-price movements, most will even express displeasure when hedging programs of any sort are contemplated. It is no surprise that managements of E&P information mill 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. Compared with unsecured mezzanine debt at approximately 18% and private equity at 25%, secured debts are extremely inexpensive, and thus, widely sought after. The most commonly used vehicle for accessing secured debt is the syndicated bank-borrowing- base facility, a revolving loan having a two- to three-year term best known in the industry as an “RBL” or reserve-backed loan. These loans use an independent third-party engineering report, with the bank’s own assessment of future pricing, to gauge the “base” amount of the loan facility. Generic terms are usually the lesser of either 50% of P1 (total proved reserves) or around 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 having an engineering report demonstrating a PV-10 (the current 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 line of credit. These loans have various customary restrictive covenants. Most significantly, however, the base amount is “reset” periodically (typically every six months), adjusting for asset acquisitions and divestitures, the near future quantity and cost of reserves, and pricing-deck assumptions. Because of the extreme volatility of their time commodity prices, the latter impacts the calculation most dramatically, both while on an absolute basis and coming from a surprise/uncertainty perspective.
In our example, when the forward price curve had declined 40% after 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 must pay back the $26-million contrast between the original $65-million RBL and the adjusted $39-million RBL. This can be 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 financial markets, the only other options are asset sales, corporate sale or bankruptcy.
Commercial banks and investors that loan cash on a secured basis are certainly not investors in your company. Despite all the friendliness and fanfare shown from your relationship banker, its only job when originating or playing a borrowing-base facility is always to ensure that it loans capital on an almost risk-free basis. That’s why the interest rate is priced in a huge selection of basis points above Libor, the interest rate at which banks lend money one to the other on a short-term basis.
The bank’s security is in keeping the actual use of the loan short (six-month resets) along with making sure there are enough assets backing its capital so that should those assets have to be liquidated, it would recover 100 cents about the dollar loaned. When a bank encourages a company to hedge, generally this is due to it increases its fee. Unless it's reducing its rate or helping the RBL borrowing-base calculation formula to be the cause of the additional security, it is just interested in the fee.
Fundamental equity investors are only somewhat better off, meaning that a cash-flow hedge covering two years of production may avert triggering a cash-flow-related loan covenant for the short term. However, given that obviously any good generic RBL has value-related covenants (debt-to-capital; debt-to-equity) de- signed to guard against balance-sheet (not cash-flow) insolvency, the protection is minimal at best. When a company employs a RBL to capture the main advantages of a lower blended cost of capital, it is shouldering additional commodity-price-liquidity risk. Unless the complete value of the RBL has been hedged, this risk is borne with the equity holders.
It is possible to way to quantify the price tag on that risk? Yes: it’s the cost of adding commodity- price insurance to the total balance in the RBF versus the substitution cost of unsecured mezzanine debt. Commodity-price insurance coverage is available in the form of premiums covered put options. Many managements would think this is outrageously expensive like a benchmark, consider the approximate 18% price of capital demanded by unsecured lenders. These unsecured lenders, in contrast to the secured RBL syndicate, are investors with your company. Since their investment is not completely covered by the nominal liquidation from the assets of the company, these people have a true stake and alignment inside the management of those assets for future growth and value.
In other words, an unsecured, preferential investor in naked E&P assets requires a hurdle return of 18% along with a private-equity investor demands 25%. Any funds that can come below those rates are not bearing any true operational, fundamental or commodity-price risk. Any organization that uses low-nominal-cost, secured RBL financing should recognize that it is materially increasing the likelihood of distress and bankruptcy because of its true investors. The cost of that increased risk is explicit because the difference between the price of financing using only unsecured mezzanine debt as well as the price of financing employing a RBL that has been fully hedged using energy price puts. A firm can also shift that risk to 3rd parties by using swaps, forwards and collars- i.e. by increasing its hedging program to pay for the total value of the RBL. While forward sales and similar tools do not have an instantaneous income-statement impact, as compared to the expense of premium paid on commodity-price put options, the corporation has given up significant operational and strategic flexibility and thus, has chosen on bearing as significant an amount as the explicit tariff of put-option premium.
Introducing strategic hedging
The two basic elements inside a strategic hedging program are: 1) knowing that hedging is about minimizing the risk associated with major decision-making, and two) that hedging is most properly viewed negative credit the cost of capital, not as a line-item cost on the income statement.
Going back to the roots of commodity-price hedging, the farmer’s goal wasn't to smooth seasonal income, but rather to make sure that the logical strategic decision he earned to plant crop x, which has been based on all of the information he'd access to at the time of planting, would not result in financial disaster after the harvest solely because prices had changed. Likewise, when an E&P firm makes the strategic decision to formulate and produce an oil and gas field, or to purchase or merge having a competitor, it can usually take into consideration the price environment that exists during the time of investment. A strategic hedging plan would con- sider the complete duration of production and also the value of being able to follow an initial plan irrespective of 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 need to move away from a myopic pinpoint the income statement and set those costs negative credit the income statement, cash-flow statement and balance sheet; that is certainly, they need to understand how hedging may affect their expense of capital.
Surprising as it might 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 keep up a strong liquidity position and doesn't rely on secured debt as the primary financing mechanism underlying its enterprize model. The relatively low levels of net debt carried by the company are not accidental, but alternatively a strategic decision.
Strategic hedging is around 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 actual popular methodologies overemphasize monthly volumes and basis risk, and underemphasize value of decision-making optionality and flexibility. The result is that hedging has become a tool for smoothing quarterly results plus a major profit center to the secured lenders.
Meanwhile, businesses 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 often an afterthought at operationally focused E&P companies. Management will be well advised to invest the identical effort in engineering the security and soundness of its capital structure as it does in the oil and gas fields that compose its assets.