Unprecedented price decline presents hedge optimization opportunities
As a result of the significant decline in crude oil prices, E&P companies who are well hedged might have hedging gains which at similar to or exceed the prevailing price of crude oil. This is great, but what do you do now? We’ve reviewed this several times in the past and here is a summary of the various ways to think about it. To do so, let’s assume an E&P company has $60 Brent swaps that are $35 in the money, with Brent at $25.
Option 1: Close hedges, take the cash and run
It feels nice to take the money. You made your bet, held your cards, and won the pot. Well done. But what are you really getting and what risk are you left with?
“When does one take gains (or losses)?” is one of the most difficult questions to answer in all of trading, not just hedging. You will always be wrong if you don’t have a plan going in. Continental Resources provided a prime example during the late 2014 oil price decline, monetizing its then current hedge positions at an less than ideal time . If your hedges are $35 in the money, though, the decision might feel obvious. At $25 oil, your gains are probably necessary to keep you alive. Unfortunately, buying back your position also leaves you exposed to further declines. So what do you do?
No one says you need to close the entire position all at once. One may consider closing a portion of the portfolio and devising a plan for ongoing optimization based on how the upcoming weeks and months play out. For example, let’s say our hypothetical $60 swaps were for the calendar year of 2020. One might realize gains on just the summer months if you had committed operations that could not be shut down and needed that cash. If you deem it necessary to reduce activity in the fourth quarter, you might also reduce that position to reflect that lowered need for hedges. It would take a bit of spreadsheet work, but generally, one can find a good way to balance the extreme between do nothing and close the entire position. Part of that calculation might include comparing the gain to the dollar amount necessary to meet the risk management goals you already had in place. It’s possible with such a sizeable gain that it only takes a portion of the portfolio to meet that goal, leaving the rest in place to protect against further downside. No matter how you do the math, it makes sense to think about monetizing less than 100% of your position given the market is still at peak volatility with risk of lower prices.
Option 2: Close hedges, take the cash and buy puts
Given our assumption that hedges are in the money, that gives you a bit more flexibility. Option 2 is really an extension of the math we described in Option 1. Although at these levels of volatility, put options might seem expensive, keep in mind that you are sacrificing a portion of your gains from your swaps, so it is kind of like playing with house money. (I realize that winnings are no longer house money once you collect, but you know what I mean.)
If you spent $3.75 of your $35 gain, for example, you might buy a $25 put that covered the second half of 2020. This would protect you from further losses while giving you full access to the upside and you have realized a net $31.25 hedge gain. Although $3.75 on a put at $25 might sound expensive, in context of the hedge optimization process, it is a great value. In other words, you are sacrificing just $3.75 of your $35 gain to guarantee your hedges not only continue to provide insurance, but that all the benefit that has accrued to date will stay in your pocket.
If $3.75 is too rich, you can look at lower strike, of course you give up some protection. $20 puts trade around $2.25 and $15 around $1.15. Alternatively, one might construct put spreads with those. For example, buy the $25 at $3.75 and sell the $15 at $1.15. Your net cost would be around $2.60 and your hedge would protect you between $25 and $15. Word of caution here, in times of high volatility, the bid ask can be quite wide, so you might sacrifice 30 cents or more on the net cost. In other words, the cost of that put spread might be closer to $3. In that case, the $25 put at $3.75 looks to be a better value. We seldom recommend put spreads to E&P companies, but at prices this low, you might find some value there. Just don’t do something like sell some calls, as well. You don’t want to be the next company to make headlines with a terrible 3-way hedge.
Option 3: Buy Call Options
The third and final thing to think about is something that few E&P companies ever think about, but that most undergraduate finance students learn about: the synthetic put. A synthetic put is constructed by selling a swap (or any fixed price instrument) and purchasing a call on the same underlying and for the same tenure. In the text book demonstration, it is usually at a strike equal to the fixed price swap price and the two are often executed simultaneously. Neither of those are requirements, though. Buying a call now might prove quite useful. First, you have the entire spectrum of strikes from which to choose. Second, it allows you to maintain your hedge and reserve the gains, as needed.
One might sell a portion of the in the money portfolio to finance the purchase, following the same guidelines described in Option 1. The remaining swaps in place, combined with a purchased call transform the portfolio into a long put. From here, your net position will behave just like a put in the market to market. You will have gains in the call offsetting any losses in the swaps and the swap gains will accrue without sustaining any losses in the call. It is the right to the gains without the obligation that would have been created with a put, just constructed in pieces. For example, a $40 Brent call for the June-December 2020 strip might cost about $2.75. If you purchased a $40 call of equal volume to your existing hedges, your net in the money mark to market would be $32.25, but you’d have the added benefit of gains on the call as the market rebounded. In a scenario where Brent rose above $40, your call would be in the money. In fact, even if Brent rose to $100 somehow before the end of the year, your combined position would remain $20 in the money [($100 - $40 call) + ($60 swap -$100) = $20] – win, win!
As you can see, there is no shortage of menu items when it comes to optimizing energy price risk management strategies. Ultimately, you need a hedge portfolio which is best suited to your company's specific needs and circumstances. If you would like to discuss how we can help you optimize, upgrade or develop your energy hedging program, please contact us.