Good morning #EFT and #fintwit. Seen lots of discussion around hedging but very little detail. I'll do a few threads on why we hedge, the process we utilize, counterparties, documents and various structures. All will be through the lens of hedging a commodity business. Let's go!!
Why do we hedge? Insurance. In most commodity-based businesses, significant volatility exists in supply/demand rebalancing over time. This creates uncertainty in cash flow that can degrade the value of the business and create operational difficulties.
Additionally, if there is any kind of debt financing on the business there are likely covenants requiring a certain baseline of hedging. These have evolved over time, but the majority I've seen recently are a minimum of 50% of certain production volumes over the next 8 quarters.
Now - the question is what is the optional "size" for a hedge book. This answer will vary by company. First and foremost, we hedge to protect our interest expense and G&A. If you can't pay interest you lose your company. More importantly you never want to lose anyone.
In our business, we also look to hedge a minimum amount of cash flow each year for opex, baseline maintenance, and some cash flow (read: cushion).
What this ultimately looks like for our business is an 80/60/40/20 split over the next 4 years. Where we look to lock in 80% of anticipated production (generally 1P) next year, 60% 2 years out, etc.
We do not hedge to hit these quotas in a vacuum. 2020 was a good example: a geopolitical event happened early in the year that spiked prices and led us to overhedge 20 and 21 to almost 100% of anticipated production.
This worked out nicely for us when prices fell in April 2020, but we didn't add any hedges for almost a full year. We've been catching up on volumes in 2022-2024 as prices have rallied through 1H21.
One push back we get often is that we are capping our upside by hedging so much of our production. For private equity backed companies, the majority of value comes in a sales event. Don't take risks the entire 3-7 years you operate, just take risk on timing of sale.
Another way to look at this is if you produce 1mmbbls annually (flat prod profile), I'm suggesting you hedge ~2mmbbls total using 80/60/40/20. When you sell, you might have 20mmbbls of reserves, or 10x the unhedged barrels. Keep your business alive and your people employed!!
That's the first thread. Will put together more detailed specifics around the logistics of hedging and the structures that are often used soon.
If anyone is curious, our hedge book peaked around 30 mmbbls of Brent crude, 50 bcf of Henry Hub + basis and $400mm of rates hedges. That's over $2 billion of exposure. Small potatoes for some traders, but it's been fun.
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