Turning the Tide in Volatile Markets

Mitigating Oil and Gas Price Risk with a Commodity Hedging Program
Scott Smith, Cambridge Global Payments, Calgary

The evolution of the financial market landscape over the past year has been a tenuous one for most participants. It has been especially exasperating for commodity producers as the free-fall in hydrocarbon prices has left oil and gas producers scrambling to remain afloat. The heightened volatility in oil markets as a result of supply and demand imbalances, combined with a rising US dollar as the Federal Reserve becomes more comfortable with embarking on a rate tightening cycle, has left many players on the production side assessing the merits of instituting a commodity hedging program.

It may appear as if once a decision has been made on whether or not to implement a commodity hedging program the bulk of the planning is done. However, the successful execution of the program depends on the assessment of a number of risk factors that can sometimes get lost in the whirlwind process of getting such a program off the ground. This article will explore some of the risk factors that need to be addressed for producers implementing a commodity hedge program when the organization’s functional currency is something other than the US dollar, as turning a blind eye to foreign currency implications could derail an otherwise successful hedging regime.

For oil and gas producers that operate in a functional currency outside the US dollar, the execution of a hedging program to protect future revenues will likely, depending on the specifics of the initiative, create exposure to foreign exchange markets. Take for example, a producer in Canada that gets paid in Canadian dollars based on the price of Edmonton Par. The producer would like to hedge its future production in order to protect cash-flow for the upcoming year, but the only available hedging tool to lock in a future price is to take a short position in West Texas Intermediate on the Chicago Mercantile Exchange. Ignoring the basis risk inherent in proxy hedging the Edmonton Par price with WTI, because WTI is priced in USD, the initiation of a short position in the reference asset has now created a foreign exchange exposure, and thus one more risk that needs to be managed in order to reduce slippage in the overall performance of the program.

Given a decision has been made to protect future revenue for either cash-flow or budgeting purposes, this article explores the considerations for incorporating the foreign exchange implications into the overall program, specifically discussing the merits of Exchange Traded versus Over-the-Counter (OTC) derivatives, along with product and strategy selection.

One of the earliest decisions involved with incorporating FX hedging into the overall program is whether to utilize Exchanged Traded or OTC derivatives when executing. On the basis that many commodity hedges will be of the exchange traded variety, for simplicity sake, the decision is also made to hedge the FX risk via an exchange using standardized futures contracts.

While there are a number of benefits to utilizing standardized futures contracts, using an OTC brokerage adds additional flexibility that can enhance the effectiveness of the overall program. The ability to negotiate more flexible credit terms with an OTC provider versus the standardized margin terms inherent with exchange-traded derivatives can improve a company’s cash-flow, which is an important consideration in any market environment.

In addition, the capability to book in odd-lot sizes and non-standardized delivery dates when dealing in the OTC market can better align the hedge book with production schedules, thereby decreasing basis risk from hedging mismatches due to notional amounts and tenor. Furthermore, it is very common for the front-month futures contracts to be the most actively traded and therefore have narrow transactions spreads, whereas contracts with long-dated expiries have wider bid-ask spreads because of volume constraints. Conversely, the OTC market is extremely liquid up to 18 months, giving participants a greater likelihood at decreasing execution costs when hedging longer time periods.

The ability to deal in long-dated contracts in the OTC market also helps eliminate any basis risk from booking short-dated futures and having to roll on a consistent basis to correctly match delivery times, both decreasing transaction costs and slippage from a changing futures curve. Even though dealing in the OTC market will create credit risk on behalf of both transacting parties given the absence of the clearing house characteristic of exchange traded derivatives, the increased flexibility the OTC market provides will likely enhance the success of the program and reduce slippage concerns.

Another consideration when it comes to incorporating an FX hedging strategy into a broader commodity hedging program is what strategy will be used when executing. There are many ways to tailor a specific currency overlay strategy to the risk tolerance of the organization in question, but for the sake of simplicity, the two main strategies would be either passive or active. A passive currency overlay strategy would hedge 100% of the FX exposure associated with the short commodity position, matching timing and amount in order to lower any basis risk. In theory, the commodity and FX hedges would be placed simultaneously, effectively eliminating any price risk over the stated time period and securing budgeted cash-flows.

A more active approach to the hedging program would allow for varying hedged amounts based on market outlook, while assessing different products and strategies outside of vanilla forwards (or futures) contracts. Strategies that encompass some form of optionality (whether through structured products or outright bought vanilla options) are becoming popular given the heightened volatility in both commodity and FX markets.

The diversification inherent in option-based hedging strategies can help lower the potential for out-of-the-money settlement scenarios, though there is always a trade off as the risk/reward parameters are skewed when compared to a traditional vanilla hedging strategy.

Another benefit of structured products where hedge amounts are varied is that they can (depending on the strategy employed) help eliminate the binary pay-out nature of a vanilla option hedging strategy, though when looking at active currency overlay strategies it is wise to incorporate a diversified product mix.

Given the current market environment with an upwardly trending US dollar and elevated levels of volatility, an active overlay strategy is likely to outperform a passive vanilla approach to currency risk management, helping to eliminate some of the traditional costs associated with hedging.

Regardless of the market environment, it is paramount to recognize that the implementation of a successful commodity hedging program goes far beyond the decision to protect future revenue streams. In order to create an effective project, a specific framework needs to be put in place that outlines the objectives through to how execution will occur.

Creation of a hedging policy document is principal in drawing the roadmap for success, but it must be adjusted and modified as time goes on and results are reviewed. Michelangelo didn’t paint the Sistine Chapel in a day, and a successful hedging program that takes into account risks and opportunities outside of just the commodity in question can’t be created overnight.

ABOUT THE AUTHOR

Scott Smith, CFA, is a senior market analyst for Cambridge Global Payments. He has a diverse background in the foreign exchange industry, with previous experience in both credit and trading related functions. Smith specializes in identifying and evaluating hedging strategies to assist corporate clients in effectively managing inherent risk in their business models, while providing market knowledge to manage risks on a dynamic basis. He is a contributor to Cambridge’s Morning Commentary and has been featured on WSJ, Forbes, Reuters, and Bloomberg.

Read the full article here: http://www.ogfj.com/articles/print/volume-12/issue-5/features/turning-the-tide-in-volatile-markets.html