Category Archives: hedging

Sweeping for cash in the hedges

April 1, 2012 – 8:58 pm

Natural gas producers in the US are faced with tough choices. Advances in drilling technology have made low cost production from shale resources viable on a large scale, and the industry has been in a race to lay claim to the most valuable properties and to capture a competitive advantage in mastering the technology. But at the very same time, the price of natural gas has collapsed, erasing profits. This has pinched budgets and forced companies to be creative in finding fresh sources of capital. It has also forced companies to re-evaluate development plans and resource acquisitions.

The price of natural gas in the US has been falling almost continuously since mid-2008 when it peaked at over $13/mmBtu. It now lies just above $2/mmBtu.

Despite the falling price, natural gas production in the US has continued to climb. According to data from the EIA, between July 2008 and January 2012 US production increased 17%. Companies have been slow to adjust their expansion plans to the falling price. Finally, in late 2011 and early 2012, companies have begun to adjust their capital expenditures to the current low natural gas price reality. Gregory Myers has reported on this in the Financial Times, citing decisions at Chesapeake Energy and ConocoPhillips. In 2011, Encana Corp finally confronted reality and abandoned its 2008 pledge to double production.

Even as capital budgets are cutback, companies still face a need to raise new cash. The new technologies can also be applied to production of unconventional oil resources, like the tight oil in North Dakota’s Bakken Shale or Texas’ Eagle Ford Shale, as well as to development of liquid rich gas fields. Since the price of oil remains high, it can pay to develop these resources. But many natural gas companies with experience in the new technologies find themselves cash poor due to the low operating profits on their gas properties. Cash poor, and prospect rich.

These companies are selling their traditional gas assets to buy higher value shale deposits. Equity issuance is also at historically high levels. Dealogic estimates that share issuance by the sector represents one-fifth of all the US equity raised this year.

A more interesting development is to get cash from accrued gains with pre-existing hedges as reported by Ajay Makan in the FT. An example would be of a company which had entered in 2009 into short positions in forward/futures natural gas contracts for the next six years, until 2015. Right now, in March 2012, the company has on its books gas contracts with maturities varying from June 2012 to 2015. Since the gas yield curve back in 2009 when the company initiated the positions was significantly higher than the current gas yield curve, the company is sitting on significant unrealized gains. Consider just one of its many futures positions: 1000 contracts sold in 2009 with maturity March 2014. The price in 2009 of a March 2014 contract was around $4. Now the same 2014 futures price is around $3.4. Since each contract is for 10,000 mmBTU, the company can close the position and make a profit of 10,000 mmBTU x ($4-$3.4) = $6,000 per contract, for a total of $6 million.

The companies can close out these contracts in order to cash in on the gains.

A couple of questions are in order:

1. Why would the companies want to do that?

2. If the companies sold the hedges wouldn’t they become unhedged and exposed to greater risks?

The answer to the first question lies in the fact that with low gas prices, companies are not able to generate enough cash from operations to fund investment in land, drilling and exploration of shale gas fields, when the industry faces a lot of competition to own such assets.  Faced with an operating cash squeeze, the companies are tapping their reservoir of gains generated by pre-existing hedges.

But, going forward, won’t the companies be much more vulnerable to price gyrations if they liquidate their hedges?

No.

The companies can immediately lock into new forward contracts at the prevailing forward price. The companies are simply realizing past gains on their outstanding contracts in order to plough the money back into their businesses. Unrealized gains are a wasted resource. The companies are free to establish new hedges. Analysts who claim that companies are taking on more risk to avoid cutting back on investment are just wrong.  There is not a conflict between cashing in on unrealized gains from past hedges and being hedged going forward.

By John Parsons & Antonio Mello | Also posted in commodities, financial policy | Comments (0)

The quickest way to a conclusion, … jump.

March 28, 2012 – 9:53 pm

Earlier today, the consulting firm IHS released a report decrying the horrible consequences that the Volcker Rule would have for the US energy industry and the economy.

It’s a hatchet job.

Why?

Read More »

By John Parsons | Also posted in commodities, Dodd-Frank, markets, OTC reform | Comments (15)

Temporary Hedges eventually force Deleveraging

March 15, 2012 – 2:01 pm

Companies are often required to hedge when taking a loan, and especially companies with volatile revenues and little flexibility to quickly adjust their costs to stabilize earnings. Creditors care about being paid back, so they worry that the firm does not fall into a state of low earnings. Hedging reduces the likelihood of that happening, and consequently increases the borrowing capacity of a company.

The problems of Energy Future Holdings (EFH), recently reported in the press, highlight an interesting issue of maturity mismatch between hedging and (excessive) leverage.

What are the problems?

EFH was created in 2007 when a group of private equity investors paid $45 bn to acquire TXU, a Texas power company. The takeover, at the height of the buyout period before the financial crisis, was financed with a debt-to-equity ratio of 4.625X. The deal required EFH to hedge its medium term revenues.

A number of things have happened since then: The development of drilling techniques that tap large deposits of natural gas trapped in shale rock formations in the US and Canada. To make things worse, the deal was signed during a period of high gas prices, prompting many power companies to switch to alternative sources of energy.  The additional supply and reduced demand led to a sharp fall in the price of natural gas, currently hovering around $2.30 per BTU. Even if this price makes gas powered turbines attractive, it takes time to convert existing facilities and build new ones.

EFH uses gas price as a proxy for the Texas electricity price. It shorts natural gas derivatives to make money when the price of the commodity falls. The profits from trading gas derivatives offset the decline in revenues from selling electricity at prices indexed to the spot price of natural gas.

The problem is that the hedges covering the anticipated generated output have been declining over the years and will expire in 2014. By then the company will be highly exposed to natural gas prices, and unless these prices recover significantly, the company will not be able to repay the maturing debt.

Currently, 5-year CDSs on EFH debt have an implied rate of 9.5 per cent. Without much hope, creditors have been writing off a significant portion of their loans. This is, in effect, deleveraging. They have also agreed to extend the debt maturities in a gamble that gas prices will rise significantly. This is not consistent with the slight increase in the natural gas futures curve over the next two years.

The example of EFH shows how hedging, or for that matter financial derivatives, can be used to hide more fundamental problems with many leverage deals: That temporary gains in hedges cannot support excessive long-term debt.

Without these temporary hedging profits, investors in EFH are being forced to deleverage. They can do it voluntarily as they seem to be doing, or they can do it through bankruptcy.

By Antonio Mello | Also posted in credit risk | Comments (1)

Can Hedging Save Greece?

February 23, 2012 – 8:18 am

As a part of its restructuring of debt, the Greek government has decided to issue GDP-linked securities:

Each participating holder will also receive detachable GDP-linked Securities of the Republic with a notional amount equal to the face amount of the New Bonds of the Republic issued to that participating holder. The GDP-linked Securities will provide for annual payments beginning in 2015 of an amount of up to 1% of their notional amount in the event the Republic’s nominal GDP exceeds a defined threshold and the Republic has positive GDP growth in real terms in excess of specified targets.

The payout on these securities goes up and down with the country’s ability to pay. Yale professor Robert Shiller has been advocating this type of financing for a while, including in the most recent issue of the Harvard Business Review. A small number of countries have tried this before. The recent case of Argentina is notable since its GDP-linked bonds have paid off handsomely.

What about the U.S.? Could GDP-linked bonds be helpful in managing this country’s debt burden? That’s the case the advocates are making. Although the idea isn’t yet mainstream, it has at least made an appearance deep in the slide deck delivered by the Treasury’s Office of Debt Management to the Treasury Borrowing Advisory Committee last year.

Not everyone is enthusiastic about the idea.

By John Parsons | Also posted in credit risk, debt/liabilities, financial innovation, financial policy | Comments (1)

The True Cost of Government Guarantees — Take 2

February 17, 2012 – 8:25 am

As part of the fallout from last August’s bankruptcy of the Federally-backed solar firm Solyndra, the Obama Administration appointed Herbert Allison, a Republican banker and former Treasury official to review the Department of Energy’s loan guarantee program. His report was completed at the end of January and released earlier this week. It contains many useful observations and recommendations and is criticized as well for what it doesn’t contain.

I want to use this post to focus on one specific issue: the correct measure of the cost of a government loan guarantee. In an earlier post about a recent CBO report on the nuclear loan guarantees I described how the current, legislatively mandated method for calculating the budgetary cost significantly understates the cost because it ignores the full cost of the risk imposed on taxpayers. Future payouts on the guarantees are discounted at US Treasury rates, but the true cost of those future payouts should include a market risk premium. I used the CBO report to estimate that the underestimate of the cost of the guarantees for the new nuclear plant at Vogtle amount to $640 million. The Allison Report tells us something about the underestimate on other parts of the portfolio.

The key comparison is between the last column of figures in Table 4, where the cost is estimated using the legislatively mandated FCRA method that ignores the price of risk, and the last two columns of figures in Table 6, where the cost is estimated using the FMV or fair market value method that uses the market price of risk. In total, the FCRA subsidy cost is $2.682 billion whereas the FMV subsidy cost is between $4.970 and $6.839 billion. Taking the FMV cost as the benchmark, the FCRA cost ignores between 46 and 61% of the full cost to taxpayers because it ignores the price of risk.

Read More »

By John Parsons | Also posted in insurance, pricing risk | Comments (0)

The Value in Futures

February 3, 2012 – 7:58 am

Today’s Wall Street Journal has a piece by Ian Berry about the possible restructuring of the CME’s rice futures contract. The design of the contract determines how effectively “farmers, elevator operators and beer brewers” can use the contract to do their hedging. The article is about problems that have shown in up in recent times and proposals to fix them. These problems impact how farmers and others manage their operations and investments:

“We are losing rice acres to other crops, and the lack of ability to comfortably hedge is a major reason,” said John Owen, a Louisiana producer who has chaired a committee with the U.S.A. Rice Federation, a trade group, to examine the issue.

Farmers said growing rice becomes too risky if they can’t lock in prices at the start of the season. Most of their expenses come up front, so they need some assurances on what they will get for their crop.

“We need to get our rice farmers back to farming rice,” said John David Frith, a farmer in East Carroll Parish, La., where a vast majority of growers have stopped planting the grain.

Designing the terms of a futures contract is a tough problem. Getting it right is how a market like the CME helps make the economy more productive.

By John Parsons | Also posted in commodities, financial innovation, financial policy, markets | Comments (0)

The Promise and Pitfalls of Indexed Debt

October 25, 2011 – 4:34 pm

The promise

We saw two recent commentaries by eminent economists advocating the use of indexed debt instruments.

Ken Rogoff, of Harvard’s Economics Department, was interviewed in the McKinsey Quarterly about the current Great Recession and what can be done about it. Among a number of other points about long-run structural reforms, he says that:

And then I’d say governments need to find ways to spark market innovation in indexing debt instruments. If we had housing loans indexed to, say, regional housing prices, as Bob Shiller has advocated, it would have helped a lot and provided better incentives to borrowers and lenders. If in 200 or 300 years, we’re experiencing fewer and milder financial crises, it will be because we figured out how to put some basic indexation clauses into debt that make it a little less vulnerable to systemic risk.

Read More »

By John Parsons & Antonio Mello | Also posted in financial innovation | Comments (4)

The True Cost of Government Guarantees

September 29, 2011 – 4:22 am

The August bankruptcy at the solar panel manufacturer Solyndra has generated a predictable political kerfluffle, since the company had received $527 million in loan guarantees from the Obama Administration. The political issues raised by the case are fair game. But I’m more interested in a more general issue:

What is the true cost to taxpayers of loan guarantees?

Obviously, we learn the cost of a particular loan guarantee, like the one for the bankrupt Solyndra, ex post—it’s the amount of money the government has to payout to the creditors. But what is the right estimated cost ex ante?

Coincidentally, August was also the month that saw the CBO publish a report on the true cost to taxpayers of Federal Loan Guarantees for the Construction of Nuclear Power Plants.


 Read More »

By John Parsons | Also posted in insurance, pricing risk | Comments (1)

The Volcker Rule & Trader Compensation

September 29, 2011 – 3:34 am

A Bloomberg article details how a draft of the Volcker Rule uses the structure of trader compensation to distinguish between proprietary trading and market making. Exactly right!

By John Parsons | Also posted in governance, incentives | Comments (0)

Lesson from UBS on trader compensation

September 28, 2011 – 8:55 am

The case of the $2.3 billion trading loss at UBS holds many lessons for any company that trades derivatives. Remember, UBS wants to claim its trader was a rogue that victimized the company. There was a time that a bank could shout ‘rogue’ as an effective excuse of senior management. But that time is now long past. There have been plenty of penetrating questions asked about the self-evident shoddiness of UBS’ control systems. Another area that deserves scrutiny is the compensation system. How is a trader’s pay determined?

Pay should be for performance. But what counts as performance?

The metrics for performance on a proprietary trading portfolio should be different from the metrics for performance by a market maker. A market maker ought to be compensated, in part, for how successfully s/he is hedging trades. For a market maker, outsized gains on the unhedged component should not count towards a bonus, whereas for a trader running a proprietary portfolio, they should.

How was performance measured at UBS’ Delta One desk? If the traders were being rewarded based on the total profitability of the desk, then UBS was incentivizing them to speculate, and the Delta One desk shouldn’t be described as customer facing or market making.

This same lesson applies to non-financial companies that hedge through their own trading desk. The metrics for performance on hedging should incentivize minimizing risk. The metrics should measure risk reduction. When the desk reports big profits — after netting out the matched positions — that’s a bad sign, not a good one.

If you pay out bonuses when bets payoff, be prepared to see some bets that lose big, too. It’s not a rogue trader if the risky bets are rewarded by the compensation system.

By John Parsons | Also posted in governance, incentives | Comments (1)
Follow

Get every new post delivered to your Inbox.