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03 Dec 2015
A holistic approach can rein within the overall risk-reward proposition for investors, employees and management.

Almost all 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 both the process and results.
oil

Secured-debt investors include the only participants that seem genuinely enthusiastic about hedging; however, because they often are commercial banks which might be bundling hedging services with loans, it's 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 alternative perspective on managing commodity price risk, an approach we characterize as “strategic hedging”.
hedging

 
Roots in agriculture

Price hedging techniques and methods emanated from the agricultural markets. Farmers wished to lock in price certainty with a portion of their crop during planting in an attempt to avoid financial ruin from adverse price movement during the time of harvest. The use of the forward activities was governed by the duration of the time of year, resulting in contracts typically starting from three months to one year.

Since the farmer could alter his decisions on crop allocation each and every season, the use of the hedge naturally matched the duration of the commitment period. Thus, hedging implementation practices evolved that focused mainly 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 along with the deregulation of natural gas markets from the latter half of the twentieth century increased the realized volatility in energy commodity prices. Markets for standardized energy contracts emerged, mimicking the increase of agricultural futures exchanges. Notably, though, the strategies for designing and implementing hedging policies, which were molded in the agricultural futures pits in Chicago, were not substantially altered. Today, the same methodologies are employed in both the finance and treasury departments of E&Ps and on the desks in the commodity trading departments of business and investment banks as were developed and honed inside the agricultural commodity markets of yesteryear.

The regular method is to start at time zero (now) and progress in time, estimating the number of production and the most closely correlated standardized contract. Since the futures markets’ liquidity has a tendency to decrease the farther one moves into the future from time zero, the bulk of planning and implementation is centered on the near term.

Common practice, for instance, would be to estimate monthly production volumes for 12 to Couple of years at the most, and then to select the best contracts to hedge a percentage of that volume. In the agricultural arena, in which the duration of a project (i.e. enough time from planting to reap) is limited, this technique can effectively and dramatically reduce financial risk. Unfortunately, inside the energy production arena, project duration is measured in years and sometimes decades, not in months or seasons.
Cash flow versus value

Since the duration of production greatly exceeds the scope with the typical hedging program, most contemporary commodity-price hedging programs are simply locking in a small part 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 normal North American E&P company comes with an eight-year R/P (reserve-to-production) life, even if 100% of production is hedged for your first two years, then less than 30% of the value of the assets is hedged, even considering intrinsic declines in production.

From a fundamental equity investor’s perspective, the advantages of a conventional hedging program are in most a slightly lower likelihood of bankruptcy during the covered period. Considering 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 organizations are both underwhelmed by and unenthusiastic about commodity-price hedging.
Secured debt and capital cost

Secured debt is the least expensive form of financing for E&P companies, with floating rates typically costing Libor plus 100 to 300 basis points. In comparison with unsecured mezzanine debt at approximately 18% and private equity at 25%, secured debts are extremely inexpensive, and thus, widely preferred. The most commonly used vehicle for accessing secured debt is the syndicated bank-borrowing- base facility, a revolving loan using a two- to three-year term sometimes 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 borrowed funds facility. Generic terms are usually the lesser of either 50% of P1 (total proved reserves) or as much as 65% of PDP (proved, developed and producing reserves), 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 through an engineering report demonstrating a PV-10 (the current value of future cash flows in a 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 of all, however, the base amount is “reset” periodically (typically twice yearly), adjusting for asset acquisitions and divestitures, the future quantity and cost of reserves, and pricing-deck assumptions. Given the extreme volatility of their time commodity prices, the latter impacts the calculation most dramatically, both on an absolute basis and from the 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 could be reset to $39 million. The organization would then have to pay back the $26-million among the original $65-million RBL and the adjusted $39-million RBL. This is problematic if the company won't 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 money on a secured basis aren't investors in your company. Despite all the friendliness and fanfare shown by your relationship banker, its only job when originating or playing a borrowing-base facility is usually to ensure that it loans capital with 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 to one another on a short-term basis.

The bank’s security is in keeping the actual amount of the loan short (six-month resets) and in making sure there are enough assets backing its capital in order that should those assets have to be liquidated, it would recover 100 cents on the dollar loaned. Whenever a bank encourages an organization to hedge, generally simply because it increases its fee. Unless it's 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, in the sense that a cash-flow hedge covering two years of production may avert triggering a cash-flow-related loan covenant in the short term. However, given that 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 security is minimal at best. When a company employs a RBL to capture the advantages of a lower blended expense of capital, it is shouldering additional commodity-price-liquidity risk. Unless the entire value of the RBL has been hedged, this risk is borne through the equity holders.

Exactly what is the way to quantify the cost of that risk? Yes: it’s the price tag on adding commodity- price insurance to the total balance of the RBF versus the substitution price of unsecured mezzanine debt. Commodity-price insurance is available in the form of premiums purchased put options. While many managements would think this is outrageously expensive as being a benchmark, consider the approximate 18% cost of capital demanded by unsecured lenders. These unsecured lenders, contrary to the secured RBL syndicate, are investors inside your company. Since their investment isn't completely covered by the nominal liquidation of the assets of the company, they've got a true stake and alignment in the management of those assets for future growth and expense.

In other words, an unsecured, preferential investor in naked E&P assets demands a hurdle return of 18% as well as a private-equity investor demands 25%. Any funds that come below those minute rates are not bearing any true operational, fundamental or commodity-price risk. Any business that uses low-nominal-cost, secured RBL financing should recognize that it is materially increasing the risk of distress and bankruptcy due to the true investors. The price tag on 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 utilizing 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 the total value of the RBL. While forward sales and other alike tools do not have an instant income-statement impact, as compared to the price of premium paid on commodity-price put options, the corporation has given up significant operational and strategic flexibility and therefore, has chosen on bearing as significant a cost as the explicit tariff of put-option premium.
Introducing strategic hedging

Both the basic elements within a strategic hedging program are: 1) understanding that hedging is about decreasing the risk associated with major decision-making, and a pair of) that hedging is most properly viewed in the context of the cost of capital, not as a line-item cost around the income statement.

Time for the roots of commodity-price hedging, the farmer’s goal was not to smooth seasonal earnings, but rather to make sure that the logical strategic decision he made to plant crop x, which has been based on all of the information he'd access to at the time of planting, didn't result in financial disaster at the end of the harvest solely because prices had changed. Likewise, when an E&P firm makes the strategic decision to build up and produce an gas and oil field, or to purchase or merge using a competitor, it can only take into consideration the price environment that exists during investment. A strategic hedging plan would con- sider the entire duration of production and the value of being able to stick to an initial plan in spite of unpredictable short-term price volatility.

Management teams that employ conventional hedging methods often complain in the insurmountable cost of put options, or even the opportunity costs of swaps and forwards. They have to move away from a myopic focus on the income statement and hang those costs poor the income statement, cash-flow statement and balance sheet; which is, they need to understand how hedging may affect their price of capital.

Surprising as it can certainly seem, ExxonMobil is an active strategic hedger although it does not use any commodity-price derivatives. ExxonMobil plans and executes its strategy with plenty liquidity and flexibility to completely ignore short-term commodity-price volatility. Exxon also chooses to keep a strong liquidity position and will not rely on secured debt as the primary financing mechanism underlying its enterprize model. The relatively 'abnormal' amounts of net debt carried by the company are not accidental, but a strategic decision.

Strategic hedging is about putting reins on the overall risk-reward proposition for investors, employees and management. Strategic hedgers have an interest in 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 as well as a major profit center to the secured lenders.

Meanwhile, businesses that follow conventional “conservative” policies end up finding 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 could be well advised to invest the identical effort in engineering the protection and soundness of its capital structure since it does in the coal and oil fields that compose its assets.


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