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The fundamental of oil & gas hedging
December 25, 2016

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Unlike many company of other sectors, Oil & Gas Company cannot control the price of their product. Prices of crude oil, natural gas and NGL are very volatile in nature. Therefore in order to achieve a predictable financial results, oil & gas company enters into various hedging contract.

Hedging

Hedges are a risk mitigation mechanism and protect investor against future price movement. The primary benefit of hedging oil and gas production is that it reduces the impact of unanticipated price declines (known as price risk) on its revenue.

For example: By purchasing future contract, oil & gas producer can lock the price that is favorable to them.

Common tools used in hedging

Future/forward contract:

Future contract are promise to make or accept delivery of precise quantity and quality of a commodity during specific date at exact price. It gives the buyer and seller the right and obligation to buy and sell respectively. In practice, very few commodity future contracts actually results in delivery, most are utilized for hedging and sold back prior to expiration.

Swap:

It is a derivative contract where a floating (or market) price is exchanged for fixed price or a fixed price is exchange for floating price. One leg of cash flow is generally fixed and other is variable. Buyers and sellers swap cash flow with another.

Oil & gas producers swap to fix the price against the floating (or market) price.

Put Options:

Put options gives the seller the right not the obligation to sell a specific commodity at exact price before option expiration. Put option holder has to pay a premium for put options to the other party.

Call options:

Call options gives the buyer the right not the obligation to by the specific commodity at exact price before option expiration. Call option holder has to pay a premium for call options to the other party.

Costless collar:

It is a combination of two options a put option and a call options. Oil and gas producer buy a put options (floor) and sell a call option (ceiling). The combination of both thus results in both ceiling and floor. It is costless because premium paid to buy put options is offset by selling call option.

Three way collar:

In addition to costless collar or traditional collar the oil and gas producers sell further out of the money put options (also known as subfloor) and so producers is taking more risk because if lower price put options expire in the money due to significant decline in price in that case oil and gas producers has to incur more losses. Usually, oil and gas producers sell extra put option to receive extra premium.  

For example:

Oil & gas producers sales volume for March month will be 100 bbl and Oil & gas producers want to hedge March oil & gas production.

Check for two scenarios and their impact on financial statement/revenue,

1) Market price is $40/bbl and

2) Market price is $55/bbl

Case1. Using future or swap @ $50/bbl for 100 bbl 

In first case(P=$40), Oil &gas producers receive $40*100 (Price*sales volume) =$ 4,000 as revenue from oil selling. Also oil & gas producers will receive ($50-$40)*100 =$1,000 as gain from future contract/swap and reflect as realized gain in revenue. In that case total revenue is $5,000 ($4,000 from crude oil + $1,000 as realized gain)

In second case (P=$55), Oil &gas producers receive $55*100 (Price*sales volume) =$5,500 as revenue from oil selling. Also oil & gas producers will pay ($50-$55)*100 =$500 as loss from future contract/swap and reflect as realized loss in revenue. In that case total revenue is $5,000 ($5,500 from crude oil - $500 as realized loss)

In both the case, oil & gas producers is able to maintain the revenue of $5,000. In future/forward and swap contract oil & gas producers will not get the benefit of price rise which can be achieved in other strategy linked with options

Put option right to sell @ $50/bbl for 100 bbl for premium of $1/bbl

In first case(P=$40), Oil &gas producers receive $40*100 (Price*sales volume) =$ 4,000 as revenue from oil selling. Also oil & gas producers will receive ($50-$40)*100 =$1,000 as gain from put options and reflect as realized gain in revenue. Also oil and gas producers pay $1*100 as premium for put options. In that case total revenue is $4,900 ($4,000 from crude oil + $1,000 as realized gain - $100 premium paid)

In second case (P=$55),Oil &gas producers receive $55*100 (Price*sales volume) =$5,500 as revenue from oil selling. Also oil & gas producers will not pay/incurred any loss on. Also oil and gas producers pay $1*100 as premium for put options. In that case total revenue is $5,400 ($5,500 from crude oil + $0 as realized gain/loss - $100 premium paid)

Costless collar @ Ceiling$52/bbl and floor $48/bbl for 100 bbl

In first case(P=$40), Oil &gas producers receive $40*100 (Price*sales volume) =$ 4,000 as revenue from oil selling. Also oil & gas producers will receive ($48-$40)*100 =$8,00 as gain from floor price and reflect as realized gain in revenue. In that case total revenue is $4,800 ($4,000 from crude oil + $800 as realized gain)

In second case (P=$55),Oil &gas producers receive $55*100 (Price*sales volume) =$5,500 as revenue from oil selling. Also oil & gas producers will pay ($55-$52)*100 =$3,00 as loss from ceiling price and reflect as realized loss in revenue In that case total revenue is $5,200 ($5,500 from crude oil - $300 as realized gain/loss)

 

Himanshu

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