As we’ve seen, there is a lot of knowledge and technology that goes into planning a well, much less a pad of wells, or a drilling program for a hot play like the Eagle Ford. You probably need a good map of your area of interest; you need a strong geology assessment; you need accurate and timely access to available leases; you need competitive analysis of your peers’ activity; you need an engineering plan from drilling to completion to lift; you need to know how you might extend the life of your operation.
Another thing you will need is money. Capital with a capital C. Even if you’re hedging the soft oil market with conventional E&P, you’ll need cash. And if you’re taking a leadership position in innovating modern unconventional, you’re going to need even more.
Outside of maintaining a very strong and accurate balance sheet regarding your activities, one of the most important tools in your E&P financial box is hedging. A few months ago, we explored Oil Futures: Reducing Risk in a Volatile Market and I thought it would be a good time to talk about the other major commodity hedges available: Swaps, Options and Forwards.
What Swaps, Options and Forwards have in common with Futures
- They are all types of financial derivatives – so their value is based on the value of an underlying commodity.
- You give up risk and upside – by trading a variable future price for a fixed price now, you are hedging your risk; or conversely, sacrificing your claim on an upside.
- Hedgers vs. speculators – One party in the agreement (the hedger) is trying to limit future uncertainty, the other party (the speculator) is seeking volatility.
- Reasons for current situation – The factors that affect the oil market (supply/demand/geopolitics/storage/the dollar) are still largely the same as they were in March, and affect swaps, options and futures the same as they affect futures.
SwapsCommodity Swaps have no public market – rather they are over-the-counter (OTC) agreements that deal with physical assets like oil, crops, livestock, precious metals, etc. Many swaps are run through financial services companies that tie the security to the price of the commodity. Fees are charged by the banks that set up the swap contracts.
In most cases, commodity swaps are “Fixed-Floating Swaps” – I want to sell my expected 1,000 barrels of crude oil for $55. Such and such speculator and I enter into an agreement to “swap”. They are trading their fixed value of $55,000 for the “floating” future value of the oil at delivery. If the oil is at $60 on delivery, they get to keep the extra $5 grand. If the oil is at $50 they pay me $5 grand. So they get the potential upside, and either way I get the amount I expect.
In spite of being more private than on-market trades, each business day all of these private contracts get settled in accordance with whatever jurisdiction the contract was filed under. This leads to an interesting distinction – the “notional” vs. the “net” (sometimes “gross”) value of swaps.
In the following diagram, party A and Party B have a $2 million swap contract in place. Party B and Party C also have a $2 million swap, and Party C and Party A have a $3 million swap. The notional value of these swaps is $7 million. However, at the end of the day as everything gets settled up the net value is just $1 million (between Parties C and A). However if any of the parties does happen to default, the cascade effect is pretty severe (for example the credit default swap crisis of 2008 which started when Lehman Brothers and Bear Stearns and AIG suddenly couldn’t meet their obligations).
The Bank for International Settlements, the central bank of central banks, performs periodic surveys of the international banking industry, and their Table 19: Amounts outstanding of over-the-counter (OTC) derivatives (https://www.bis.org/statistics/dt1920a.pdf) gives some insight into the scope of the global commodity swap market.
Energy commodities swaps would be a portion of the “Other Commodities” line item, showing a notional December 2014 value of around a trillion dollars.
Forwards are a subset of swaps that are futures-based, rather than just being a fixed/floating swap.
Options are another common vehicle for hedging, and many people are first introduced to options as an equity vehicle – ie “stock” options – wherein you sell or purchase the option to sell or purchase shares or stocks for a certain company in a certain period of time. Commodity options tend to be a little more flexible and are based ultimately on the commodity price instead of company value.
The elephants in the room
We’ve been burned by swaps before
Swaps are a fairly complicated instrument, and are designed to be a little bit outside of regulation, since they are comprised of private two-party contracts. Although this makes them useful for businesses who need to balance out their close-of-business books, the one-two punch of the Gramm-Leach-Bailey Act followed by the Commodity Futures Modernization Act of 2000, allowed commercial and investment banks to participate in these derivatives and then limited regulations on swaps and other derivatives, and opened the market to previously prohibited speculation that ultimately led to the 2008 crash in the financial markets. Commodity swaps tend to be a little more transparent than the credit-default swaps at the core of that debacle, but it is important to note.
The market is very emotional right now
Producers crave stability – if you’re spending money today to develop a well that will come on line in a few months, you want to know what sort of break-even points to design your drilling plan around. Futures and Swaps give you the opportunity to hedge against calamity and that’s a good thing. Those on the speculation side, however, crave volatility. And as much as 40-cent daily swings due to news articles that have nothing to do with supply or demand in the near or mid-term, they make even more on big 10-20% jumps. So don’t necessarily listen to speculators without a grain of salt.
Just as we have activist investors in the stock market (who may control a small but significant portion of the company and leverage that to outsize control of company leadership), we do see activist investors in derivatives markets. The relatively small amount of money that an investor may risk on an option, can at times give the investor more control than is warranted – with the threat of “if I exercise these options, then you’ll have to…”
Energy is the most international of industries, and coincident with every foreign trade there is an implied currency hedge vs. the dollar. So, as massive consumers such as China manipulate their currency it can have important effects.
What do you think? Leave a comment below.
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