Explainer: What is oil and gas hedging?

Companies which insured against a run on oil have been very pleased with themselves over the last month, as prices around the world have collapsed.

That’s because they organised a hedge before global oil prices began freefalling from February 19, which guarantees them a minimum price for their oil or gas.

But what is a ‘hedge’? And in normal times, when prices are not plumbing unforeseen depths, is the cost worth it?

Peter Frew, director at ASPIRE Corporate Financial Solutions, walks us through the ins and outs of oil and gas hedging.

It’s a fancy name for insurance

A hedge is a contract to fix the price of an asset and protect against any adverse movements.

For example, a home buyer does it when they choose to fix some of their mortgage to protect against rising interest rates.

With commodities like oil or gas, producers are trying to protect against downward movements in price while buyers are trying to limit the peaks.

Australian companies which price their oil in Brent, the international benchmark, use a mixture of Brent futures — contracts where two parties agree to buy and sell a product at a specific time in the future — and current or ‘spot’ prices, says Frew.

LNG companies in Australia tend to look to the JCC price, or Japan Customs-cleared Crude to which Asian gas prices are linked.

US companies, such as our ASX-listed American frackers, base their hedges on the West Texas Intermediate (WTI) price — the one that turned negative last week and at the time of writing was at $US10.82 ($16.76) a barrel.

American oil company Australis Oil & Gas (ASX:ATS) was very pleased with itself earlier this month as it had bought insurance against a WTI price drop for 80 per cent of its oil production in February until the middle of this year, meaning it’ll get an average of $US52 a barrel.

Swaps, options, collars, oh my

In Australia most companies will deal with banks or oil and gas buyers in order to fix a price, in effect setting up a contract to sell and buy at a set price for a set period of time.

This is called a swap: I swap my floating exposure for a fixed price.

Senex (ASX:SXY) had 409,756 barrels worth of oil in the Cooper Basin that wasn’t being sold under contract but in the spot market. It ‘swapped’ that exposure to the spot oil price for 15 months until June 30 next year, for a fixed price of $US90-95 a barrel.

A buyer like an Engie or a Shell buys a physical product.

A bank might act as an intermediary or its trading desk can provide something a bit different: an option.

This is how an option works: In mid-March an oil CEO notices an obscure oil price, Wyoming Asphalt Sour, is trading at -19 US cents. Sensing an impending catastrophe she buys a put option — an option to sell her oil — at a fixed strike price of WTI $US50 for the next six months.

A month later she’s proved right as WTI hits -$US37.63 a barrel. While it bounces back a touch, WTI is still trading in the teens and the CEO has oil she needs to sell now.

She sells her oil on the spot market and the counterparty, now rueing the day he signed this contract, must make up the difference.

Another oil exec wants insurance against further drops but thinks prices will stabilise once OPEC and US production cuts start to kick in, and also doesn’t want to pay much for his hedges.

So he’s found a trader willing to sell him a put option with a strike price of $US30 and has offset the fee he’ll need to pay for that with a ‘collar’, where he put a ceiling on his upside by buying a call or buy option with a strike price of $US50.

It means the oil exec gets a minimum of $US30 for his oil and a maximum of $US50 once prices start moving upwards again.

Australis hedged most of its barrels of oil using swaps, but included three collars over limited volumes to be produced this year and next, in where their price floor is $US54-55 and the ceiling is $US73 and $US77.

The price has to be right

Frew says the price will vary depending on market volatility and the range of your options.

“One of the key pricing aspects is volatility, the higher the volatility the higher the cost of the options,” he said.

“It’s an insurance premium, so the risk that the insurer has to pay out is greater [when volatility is higher].”

If the market is paying $US30 a barrel but you want to protect yourself with a minimum price of $US25, you might be paying $US6-8 a barrel for the privilege.

Once the fee is included, it means your hedge is actually $US20.

Three ways are popular again

While Stockhead has not heard of any ASX companies being stung, yet, a few US companies are coming a cropper using the naughtily named ‘three-way collar’.

A three-way takes the aforementioned collar and adds a second floor price that is much lower than the floor you want to be paid out at. For example, our oil exec perhaps added an extra $US15 floor to his deal as well as the $US30 option.

It makes the whole thing a bit cheaper and works when prices are moving within a range, as they were before February 19.

It was popular before 2014, but when oil prices dropped from over $US100 a barrel down to the $US30s “countless” oil companies were left holding big losses.

This is because it’s the lower floor that pays out, not the higher one.

Interest in three way collars had crept up over the last year and Bloomberg reports that Noble Energy, Callon Petroleum, and Parsley Energy are among the companies now looking at serious losses.