Hedge Strategy & Execution

How do hedges work?

A hedge is a financial transaction based on a future price with the intention of locking in that price.  Here are some key terms: 

• Spot prices: The daily price you receive for the physical sale of oil or gas

• Forward pricing: Prices in future months, often tracked using futures or swaps

• Swaps: Cash-settled contracts used instead of physical delivery 

• Contract for difference: Another way of describing a swap, this is a financial arrangement where the two counterparties agree to pay each other the price difference between the forward price at the time of the agreement and the settled (usually spot) price 

• Mark to market: The current value of the contract, updated daily

Financial hedges (trades) use forward prices, which are the current market transaction price for a future month. If the spot price ends up being lower than the forward price, a bank or counterparty pays the difference. When the spot price earned for the physical sale is combined with the loss or gain on the hedge, the swap price becomes the net price received. 

Example: An oil producer locks in $65 per barrel using a swap from a bank. If spot prices fall to $60, the producer sells the physical barrels at $60. However, the producer also gets $5 per barrel from the bank to maintain a $65-per-barrel net price. If prices rise to $70, the producer still nets $65 after paying the $5 difference. 

Is hedging speculative?

Hedging is not speculative because its primary purpose is risk management rather than profit-seeking. Hedging is used to protect against adverse price movements ensuring price stability and predictable cash flow. In fact, some would argue that the failure to hedge is speculative, because, if you don't lock in pricing and de-risk commodity prices in the future, you are speculating that the market price will increase. Choosing to take an unknown future market price would be a speculative bet versus locking in that price and not being exposed to market pricing in the future. 

Is my company big enough (and/or commodity exposure material enough) to hedge?

In terms of size and materiality of the risk, that's a subjective question.  Is the swing in commodity prices from a revenue or cost perspective going to affect your business? If so, then it is important to address. From a market perspective, there are companies that don't have enough commodity exposure to hedge in the market. 

In our experience, over-the-counter counterparties, which provide liquidity to the oil and gas derivatives market, tend to accept customers that produce more than 500 BOE a day. This is not a rule but is based on many observations in serving hundreds of customers. The counterparties are less likely to invest the time and money required to onboard a new customer if the anticipated hedging revenue is too small.  

From a regulatory perspective, there are rules regarding who can use financial derivatives to hedge. To be an end-user market participant, you need $10 million in assets or $1 million in equity. There are binary rules that exist to allow you to hedge.  

It is also wise to decide whether hedging your price risk is meaningful to your financial outcomes. There are standard approaches to help decide. The classic method is to model the statistical range of potential outcomes of commodity prices, test those outcomes in your own corporate cash-flow model, and determine if the worst-case financial outcomes could, for example, create a missed interest payment, cash distribution, or shortfall in return on capital.  

How long does it take to get on-boarded by AEGIS? How long does it take to launch a hedge program? 

It takes very little time to get on-boarded with AEGIS. Most clients are on-boarded in a matter of days. However, getting an ISDA (the required terms and conditions for financial derivative transactions) in place with a trading counterparty can take more than a month in many cases, so it is important to get started sooner rather than later. 

How much does hedging cost?

The cost of hedging varies depending on the method used, market conditions, and the level of protection desired.  Some costs are in the form of cash, but some are opportunity costs. For example, every trade is going to cost you in the form of a counterparty credit charge, also referred to as margin, but that cost is not an invoiced amount that requires payment. It is embedded into the price itself. In other words, you'll get a slightly less attractive or a slightly worse price on your hedge.  It is an embedded credit charge, and that is how the bank and merchant trading counterparties make their money.  

Counterparties typically charge anywhere from 1-10% of the nominal value depending on the commodity type and the liquidity of that market. The charge is based on the structure of the hedge itself and your specific credit profile, which is determined by the counterparty. 

There are, sometimes, actual cash costs, but these are almost always related to buying “options” contracts. These are customized contracts that work much like insurance policies, where you pay a premium, but you receive cash if prices decrease substantially.  

How does AEGIS make money, and does it align with the customers' interests? 

First, AEGIS hedging-advisory fees are certainly in-line with customer interests. We are paid a flat monthly retainer by our customers, by design. So rather than charging a per-unit fee for hedging advisory, we negotiate fees on the front end at a fixed monthly price and fixed term. This is in an effort to ensure there is no conflict of interest with getting paid more if our customer hedges more.  

AEGIS Markets does charge a transaction fee to dealers, but only when they win.  

Are there hedges that can give me as much upside as possible? 

Forward pricing is almost always in monthly increments. In oil and gas markets, the original hedging contract was a “futures” contract, where the buyer agreed to take delivery, and the seller agreed to deliver, at a specific time and place. However, physical delivery is often impractical, and swaps are now used for hedging. Swaps follow futures pricing but are settled with cash payments instead of physical delivery. 

Swaps can be described as a “contract for difference.” If prices rise, the seller of the swap pays the buyer the total price increase. If prices fall, the buyer pays the seller the total price decrease. When you sell a swap, it is often called a “short” position, which benefits from falling prices. A “mark-to-market” calculation determines the value of a swap on any given day, based on the difference between the forward price at the time of the trade, and the current forward price.  

Example: An oil producer hedges at $65 per barrel using a swap. If the spot price drops to $60, the bank pays $5 per barrel, ensuring the producer still nets $65. If prices rise to $70, the producer pays $5 to the bank but still receives a net $65 per barrel. Hedges ensure a predictable price by making cash payments to balance price fluctuations. 

How do I determine how much (and for how long) of my exposure I need to hedge? 

Determining how much and how long to hedge depends on your business needs, risk tolerance, and market conditions. We take financial data and run an analysis of potential outcomes in the market using statistical confidence levels to achieve your specified revenue goal. We can model how much a customer needs to hedge to give a high confidence level, like 95% chance, of reaching their budgeted revenue or better.  

Separate from business need, lenders or investors often set hedging requirements. This varies by capital provider, but in general, they calculate how much revenue needs to be secured so that the customer reaches specific financial targets. One example would be a bank that issued a loan and is trying to ensure that the customer can make interest payments. The bank would model their own scenario based on the market and the future production of an oil and gas company and determine how much they may need to hedge to cover the interest.