Are crude oil prices headed back below $40/BBL or even $30/BBL? Prompt NYMEX WTI futures settled last night at $42.92/BBL, while prompt Brent futures settled at $44.87/BBL and both are trading lower by an additional 75 cents at the moment. Recall it was only a few months ago that we witnessed crude oil trading below $30/BBL before the recovery back above $50/BBL.
As a result of the volatility and prices again trending downward, we have heard from many concerned oil and gas producers, as well as energy consumers, regarding what they should do, if anything, in this “new” price environment. The concern/excitement has rippled through the industry. This includes many companies with large and transparent hedging programs.
As you might imagine, many of these discussions begin with questions such as, “Where do you think oil prices go from here?” Or, “I am unhedged and budgeted for $X /BBL, now what?” The consumers that call are a bit more relaxed, but have similar questions, “Where do you think prices go?” Or, “How can I lock in these prices because my management team wants to protect these margins that are more attractive than budgeted?”
Although producers and consumers have different perspectives, they essentially want to know the answers to the same questions. In this post, we will address three of the most basic questions many market participants ask in times of uncertainty such as the current environment:
- Where are oil prices headed from here?
- How should I react to the drastic change in oil prices?
- What changes about hedging when oil declines by $X/BBL (or more)?
Where are oil prices headed from here?
The short answer to this question – we don’t know, nor does anyone else. If we could predict prices; we would simply trade speculative positions from our lounge chairs on the beach while counting our fortunes. The entire point of a hedge is to mitigate risk. A few quotes about forecasting from Warren Buffett make the point well:
“We have long felt that the only value of stock forecasters is to make fortune-tellers look good.”
“A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”
“Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.”
All of the same apply to oil price forecasting. Instead of discussing where we think oil prices will go, let’s discuss where prices are today, the shape of the curve, and how your business operates and will operate based on current and forward market prices.
How should I react to the drastic change in oil prices?
There’s no question that the decline from $50 to $30 and then back to $50 and now again approaching $40 has created many sleepless nights. However, a solid hedging program should include a decision-making framework that provides guidelines regarding what to do if you are unhedged as well as what to do, if anything, if you have unrealized gains/losses. It should also provide guidance in terms of how to move forward and use the data and information available today to prepare for the future, regardless of market direction.
If you lack a robust decision-making framework, turn to your budget and perform sensitivity analysis to quantify the financial impact on your bottom line with crude oil trading at $40/BBL instead of $60, or any other price for that matter. It is of utmost importance to understand the significance of the change in specific relation to your business. From there you can develop a decision-making framework based on your company’s needs. This framework should be relatively mechanical, defining in simple terms how to manage hedging on an ongoing basis. It should not include trades based on where you think the market should go, for reasons discussed in the previous section.
Once again to quote Warren Buffett, “Risk comes from not knowing what you’re doing.” Internal analysis and robust decision-making framework prevent you from trading on emotion and reacting to unpredictable markets. The mechanical nature of a framework of this nature reduces the bias of being uninformed.
What changes about hedging when oil declines by $X/BBL (or more)?
Assuming you have a robust hedge decision-making framework in place, your decision making analysis shouldn't change much, if any, in a low price environment, nor a high price environment. However, you should review your framework regularly to be ensure that it encourages activity that mitigates risk and truly meets your needs and objectives. For example, if you are an oil producer who will be cutting back operations because of lower oil prices, you will want to revisit any portion of your framework that deals with hedge volumes and adjust to reflect the lower production volumes. No matter whether you are producer or consumer, it is likely the hedging strategy that you prefer at $40/BBL is different from the one you’d prefer at $80/BBL. It is important to be aware of market conditions that affect your decision based on your own guidelines.
From an external protection, the difference in price is less important than the speed at which prices change. In other words, it is important to monitor how volatility affects your estimate of the value particular hedging strategy offers, net of the cost of implementing the strategy. Higher volatility generally leads to higher premiums for options and higher margin requirements.
Consistency is the cornerstone of a successful program.
“The best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.” – Warren Buffett.
In summation, to successfully hedge in various price environments, you need to understand how commodity price volatility affects your business, develop an analytical hedge decision-making framework, and review both regularly. A hedging program should not be market or price dependent; it should be independent of market movements because hedging should not be an attempt to benefit from changing prices as doing so is speculating, not hedging.
Conclusion
One more Warren Buffett quote for you –
“Anything can happen in stock markets and you ought to conduct your affairs so that if the most extraordinary events happen, that you’re still around to play the next day.”
That quote effectively sums it all up. Hedging is meant to support and protect your primary business, no matter what prices do in the short term. A solid hedging program is methodical and mechanical in a way that produces consistent analysis and adapts based on available information and your operational needs and goals.
We spend a large portion of our time developing, implementing and supporting hedge decision-making strategies, frameworks and policies for clients as they are the most important factors of a successful energy hedging program. As you prepare for the rest of 2016 and look toward 2017 and beyond, ensure that you are properly prepared to manage your exposure to volatile energy prices. If we can help, don't hesitate to contact us.