HEDGING PROGRAMMES
Table 1: Revenues as a Function of Underlying Prices & Main Advantages / Disadvantages of Alternative Strategies
Strategy 150
No Action: Sell production at prevailing market prices
Physical Sales 120 90 60
Simplicity. Does not introduce any of the risks that arise when a hedge programme is put in place. Revenues fully dependent on world market price fluctuations. Can lead to overreaction after adverse move.
30
50 55 60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 Oil Price Levels ($/bbl)
150 Physical Sales 120
Sell Swaps or Futures
90 Physical & Sold Futures 60
Equivalent to selling production at fixed prices Low up-front costs as no premium is exchanged. All upside is exchanged for downside protection. Potential liability if prices increase Large ‘regret’ and political implications.
30
50 55 60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 Oil Price Levels ($/bbl)
150 Physical Sales 120
Purchase out-of- the-money Puts
90 Physical & Bought Put 60
Revenue protection by purchasing insurance. Size of premiums a function of strikes selected. When volatility is high, premiums can be quite large. If options are not exercised, pressure to discontinue programme will increase.
30
50 55 60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 Oil Price Levels ($/bbl)
150
Put Spreads: Purchase OTM puts and sell further OTM puts to lower premiums
Physical Sales 120 90 Physical & Put Spread 60 30
50 55 60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 Oil Price Levels ($/bbl)
150
Costless Collars: Purchase OTM puts and sell OTM calls to finance that purchase
Source: NQuantX Physical Sales 120 90 Physical & Costless Collar 60 30
50 55 60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 Oil Price Levels ($/bbl)
No up-front premium. Downside protection. All the negative consequences for selling options or hedging with fixed prices if prices are higher. Instrument with similar behaviour as a swap outside the two strike levels.
The fund is commonly known as ‘the Oil Fund’ and its managed by the Central Bank. Its goal is to “facilitate government savings to finance rising public pension expenditures, and support long-term considerations in the spending of government petroleum revenues”. Norway’s fund is widely diversified in financial and real assets worldwide and is estimated to be $594 bn, holding 1% of global equity markets (as of June 2012).
Key Lessons Commodity producing countries can follow a series of guidelines when setting up their hedging programmes. Amongst them, we can highlight the following:
88 December 2012
1. Make an unambiguous case for hedging and formulate an explicit hedging policy statement and performance benchmarks that will be used to evaluate the hedge programme. Misalignment in the perception of the main goals and lack of a common language to evaluate the risks behind various alternative hedging strategies often result in inaction, rush decisions in a panic, and kangaroo courts looking for a culprit if there are material hedge losses.
2. Develop a system to evaluate the risk and value trade- offs of alternative strategies under different price scenarios (see section on key risk indicators or KRIs).
3. Formulate a written hedging policy that links the
Purchase insurance, but with a maximum protection payment. Lower premiums. If markets collapse, the hedge will not compensate fully the loss of revenues. Up-front premiums may be large outflows.
Revenue Diagram Highlights
Revenues ($/bbl)
Revenues ($/bbl)
Revenues ($/bbl)
Revenues ($/bbl)
Revenues ($/bbl)
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