Special Focus on Independent Oil & Gas
Chris Croom, President, Asset Risk Management
Most producers hedge a portion of their production to address cash-flow concerns or lock in opportunities. Basic hedging instruments such as fixed-price swaps and “costless” collars are popular tools for managing risk because they accomplish the intended goal at the time on implementation; they are liquid, transparent, and simplistic to communicate to a broad group of stakeholders. Hedging product offerings continue to expand to address location-based risk, the increased production of liquids, transport optimization, etc. yet many producers still are not getting optimal value from their portfolios given the typical passive approach to hedging. Producers who fail to dynamically manage their hedge portfolio in the current market environment are leaving entirely too much money on the table and accepting unnecessary risks. This dynamic approach not only mitigates price and liquidity risk but also maximizes upside participation which is of particular interest in the more recent crude oil price environment.
The more traditional passive approach to hedging whereby the producer sells a swap and holds the position for the life of the transaction has significant limitations and inherent risks. The limitations include missed opportunities to more fully participate in favourable price moves. Fixed price swaps and price collars offer price stability, but also introduce limits on the upside that comes through price appreciation.
In a period of rising prices, this upside constraint can drain liquidity and/or reduce access to capital. On day one, fixed price swaps maximize the borrowing base which is very attractive to growth oriented producers seeking to maximize debt capacity and in a falling price environment, these hedge positions can help maintain a higher borrowing base. However, the opposite is true in a rising price environment. Low-priced hedges can lead to a lower borrowing base in situations where existing hedges are priced below lender price decks. This is a real concern given that borrowing bases are typically re-determined every six months and oil and gas prices remain extremely volatile.
Active hedge management seeks to minimize risk by continually analysing implied option volatility, option skew and time spreads for opportunities to de-risk the hedge portfolio using basic hedge instruments. In this price environment there are plenty of opportunities for producers to improve their risk profiles through active management of the portfolio.
For instance, Calendar 2012 and 2013 WTI swaps are trading just under $100/bbl with the forward curve in slight contango through 2013 (i.e. priced above the expected spot price at maturity). These levels provide an opportunity to add new hedges to ensure ample price protection. If the producer employs a dynamic approach to their hedge portfolio, the market’s inherent volatility both underlying prices and option value provide various opportunities to “optimize” these initial hedges in favour of the producer. These optimizations ultimately seek the best of both worlds, gaining upside participation while also ensuring or improving the protective aspects of the initial hedge.
A dynamic approach to managing risk considers the dual objective of maximizing downside protection while de- risking the upside constraint. At ARM we consider risk tolerance, asset mix, operating metrics, capital structure and market outlook to provide the most suitable hedging recommendations to our clients.
The decision to hedge and how to hedge is not only about protecting realized revenue but these decisions have significant impact on operating cash flow, liquidity and access to capital. Actively managed, a hedge portfolio can create incremental enterprise value, operationally flexibility and access to liquidity.
Drillers and Dealers :::
::: February 2012 Edition
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