The hedger's menu

May 1, 2012
Larry Hickey offers a primer on the wide range of hedging choices available to producers.

Larry Hickey offers a primer on the wide range of hedging choices available to producers.

Larry Hickey, FRM, Contributing Editor, Oil & Gas Financial Journal

You're long oil. Prices are generally high. So you'd like to buy a few more rigs and expand the business. But everyday the price of your asset jumps around, and the bank wants to see stable cash flows before they'll make the loan. It's time to hedge. But how to do it?

Let's explore some representative hedging choices available to the oil producer. We'll start with the most basic ways to eliminate the price exposure and then add bells and whistles to generate ever more complex, custom risk profiles.

Before we start, let's address the elephant in the elevator. This stuff can be daunting and off-putting. There are countless permutations. But all this variation flows from just a few building blocks. It's like a Mexican restaurant. No matter what you order, rice, beans, and tortillas will probably feature prominently.

Comfort food

If you're long, you can take an offsetting short position. You can get flat. Here are three means to that end.

  1. Fixed price physical sale - You can sell the physical position to a counterparty at a fixed price. This will create a credit exposure on both sides. So a credit facility has to be in place. Physical sales are particularly tough on credit. Prior to the delivery, the credit exposure is the P&L on the deal. But once delivered, the credit exposure explodes to the full settlement amount. This problem exists even for a floating price sale. However, a forward sale is convenient in that the date, product and location can be tailored to match the long position.
  2. Pay float, receive fixed swap - You can enter into a swap to fix the price. Instead of a fixed price sale, the oil is sold at a floating price, or it's not sold at all. There is no credit exposure prior to delivery because the deal is always at the market price. If the counterparty fails, the deal can be replaced with a different counterparty at no loss. The swap exchanges the floating price for a fixed price. The net effect is that the oil has been sold for a fixed price and the exposure is gone. A swap is financially settled so the only credit exposure is the P&L. But it does require a credit facility. The swap can also be tailored.
  3. Sell futures - The third option is to sell crude oil futures. No credit facility is required, however there will be a daily margining process. Futures are standardized. So they may not precisely offset your long position in terms of date, product and location. Any mismatch creates a basis risk.

Let's say it's now the first of June and you want to hedge production for July. For simplicity, spot and forward prices are all $100. Crude prices are expected to have an annualized volatility of 30% going forward. The interest rate is 0. Under this scenario, each of the three instruments above would theoretically trade at $100.

The problem with getting flat is that there is no opportunity to benefit from rising prices. What if instead of eliminating the exposure, the goal is to simply reduce the risk of lower prices?

Spicing it up

You could buy a $90 put for the end of July. A put gives you the right to sell at the strike price, $90, on or before a certain date. So if prices end below $90, you are protected. If prices end above $90, the option expires worthless and the oil is sold at the market price. Such a put might cost $1.24.

We now introduce what will be a recurring theme. You like the price insurance, but you don't like the price of the insurance. What can be done?

Well, production will be available over the month, not just at the month end. So instead of a one time exercise at the end, you might buy a strip of daily $90 puts for July. Because almost all expirations will occur before July 31, the option will be cheaper. Perhaps $0.84.

But do you really need to sell above $90 each day? Aren't you really trying to protect your average price? Let's say prices oscillated between $89 and $91. The strip of daily options would pay off $1 on half the days. That's more price insurance than you may need. An Asian put, so named because Banker's Trust Tokyo office first traded them in 1987, would protect you against a lower average price than $90 at a theoretical cost of $0.70. Asian options are also called "average price options" (APOs).

Eric Lubin is a crude derivatives broker at Starsupply, a division of GFI Brokers. Starsupply is a leading US broker of oil and related derivative and option contracts. As would be expected, Eric confirms that APO's are the most popular instruments. In fact, we crossed a nominal $300 million worth of a cal 13 fence earlier today. All were APO's. We've seen particularly strong interest in APO's among physical traders based in Calgary.

OK, $0.70 is certainly better than $1.24. But I still hate having to pay it. Other than reaching into my pocket, how can I fund this price insurance?

The same volatility that might cause you harm by moving prices lower might benefit you by moving them higher. The fact that you stand to benefit from higher prices is an asset that can be sold.

So since we're comparing apples to apples, we'll focus on the average price put option that costs $0.70. That can be funded by selling the right to an average price higher than $111.71. You have bought the $90 put and sold the $111.71 call. The structure has many names: a fence, a zero cost collar, a risk reversal, or a range forward among them.

Knowing that people don't like out-of-pocket expenses, many structures will be pitched on a "zero cost" basis. But zero cost structures can cost plenty.

Interesting. So I can sell my right to gain from price appreciation. What if I was willing to do a lot of this? Is there a way that I could actually improve on the current forward level?

Why, yes, there is. Let's call it a "double up" forward. It's just like a normal forward except that you may be asked to sell twice as much oil. You can sell a normal forward at $100. But you can sell a "double up" forward at $102.77. So if July's average price ends below $102.77, you will sell at $102.77. If the price ends above $102.77, you will sell twice as much at $102.77. You have bought the $102.77 put and sold two $102.77 calls.

But I only have a certain amount of oil to sell each month. What if I agree to sell the second tranche a month later?

Even better. You can sell a "do it again" forward at $103.71. The price improvement is because the second call being sold expires a month later, applying to the average price in August. So it has greater time value. You have bought the $103.71 July put, sold a $103.71 July call and sold a $103.71 August call.

Both previous structures involved taking on additional risk for an improved forward level today. The users are having their cake now. But there are also ways to eat your vegetables now and have your cake later.

You could do the forward below the current market in exchange for a 30% participation in rising prices. Let's call it a "participating" forward. With a normal forward trading at $100, the "participating" forward trades at $98.59. If the average price for July is below $98.59, you will sell at $98.59. If the average price is above $98.59, you will sell 70% at $98.59 and 30% at the higher market price. You have bought a $98.59 put and sold 0.7 of a $98.59 call.

For those with a more adventurous palate

Or you could do a forward below the current market in exchange for the right to cancel the deal. Let's call it a "walk away" forward. Instead of $100, the "walk away" forward trades at $92.97. But it is automatically cancelled if $110 trades anytime before July 31. So there is a limit to how wrong you can be. Note that once $110 trades, you have no hedge in place and the price could plummet back down.

The "walk away" forward is our first example of a new class of options - exotic options called "barriers." The structure is made up of two barrier options - a $92.97 put with a $110 knock-out and a $92.97 call with a $110 reverse knock-out. Barrier options are like vanilla options except they come into or go out of existence when prices cross the barrier. In fact, a vanilla option can be thought of as the combination of a knock-out and knock-in option.

The term "reverse" indicates that the option is in-the-money (i.e. it has value if it could be exercised immediately) at the time the barrier hits. Barrier options exist for one reason - like Asian options, they are cheaper than vanilla options. As a practical matter, these options are rarely if ever traded in broker markets. They are generally sold by banks directly to customers, embedded in a structured product.

An issue that must be addressed as we transition to barrier options is their "opaqueness." In other words, most people are unable to price them. That information asymmetry can result in a high dealer margin. As Phoebus Kaloudis, a risk manager specializing in derivatives, explains, "Banks have a strong preference for selling complex structures. The building blocks are forwards and vanilla and exotic options, including APOs, barriers, and digitals. Assemble the bits 'n' bobs and sell it at a huge markup. I've seen cases where the margin is fully 10% of the deal value." There is a very good reason why large trading houses resist the prospect of exchange clearing of trades. The game would be laid bare.

To be fair, banks would argue that a fat margin is justified because barrier options, especially those that are in the money crossing the barrier, are notoriously difficult to hedge.

Barriers can also be used to fund price insurance with a "bad forward." In this structure, the $90 put is funded by a below market forward if $110 trades. This can look like free money because the "bad forward" is done at $108.30. That's $8.30 higher than the current forward. But at the time the barrier is hit, the forward will be $1.70 under the market. This structure consists of a long $90 put with a knock-out at $110, a long $108.30 put with a knock-in at $110 and a short $108.30 call with a reverse knock-in at $110.

The bet

A digital option is familiar to anyone who has ever placed a bet with a bookie. I bet $1 that oil is above $100 on 31 July. This is a digital call with a strike of $100, expiration of July 31, pay off of $2 and a premium of $1. Digital options will have a value of 0 or 1 at expiration, ergo the name.

Digital options can be used in any number of ways. The following "Let the rich pay" structure demonstrates the concept and seems in keeping with the current zeitgeist. Here the poor, downtrodden producer is given a $90 July put and only has to pay for it if oil finishes above $110. At that point, the rich, greedy producer is charged $3.50. The structure consists of a long $90 put and a short $110 digital option with a $3.50 payout.

Digital options pay off based on the oil price at expiration. There is some possibility that prices will move above $110 but then settle below that level. So an option that pays off if $110 ever trades is more valuable and might make more sense for the producer who plans to re-hedge at $110. This structure consists of a long $90 July put with a knock-out at $110 and a short one-touch option at $110 with a payout of $1.70. The knock-out put, which is worth virtually the same as the vanilla put, is funded by far fewer short options because the chance of breaching the $110 barrier is about twice as likely as ending up above it.

We'll stop there, though we've only scratched the surface. As these structures become better understood and commoditized, margins collapse. So the sell side must continuously "innovate" to find new ways to hide margin. The result of this financial arms race is spiraling complexity. But under the hood, we see the same building blocks - vanilla and exotic options.

Maybe you ordered a beef taco, burrito, or enchilada. But back in the kitchen, it looks an awful lot like beef, rice, beans, and a tortilla. OGFJ

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