Larry Hickey, FRM, Sapient Global Markets, London
Hedging is good. Speculating is bad. That seems to be the zeitgeist. In the US, the Dodd-Frank financial overhaul goes so far as to bar banks from proprietary trading, speculation by another name. In Europe, speculators are being blamed for the region's sovereign-debt woes.
If the simple act of declaring a transaction to be a hedge means less scrutiny, one might expect a lot of hedges. And so it is. The energy business has lots of hedges, including some mighty speculative ones.
Theoretically, hedging is the antithesis of speculation. A hedge is a transaction designed to reduce exposure to market price movements. Speculation, on the other hand, involves taking on market risk in order to benefit from price movements. One guy is getting smaller. The other is getting bigger. What could be clearer?
Well, not so fast. What is so clear theoretically can become murky in reality. As long time energy and risk management consultant and president of Houston-based Mercatus Energy Advisors, Mike Corley, can tell you, "Many hedges look like thinly veiled directional bets."
Let's look at some of the ways the line between hedging and speculating can become blurred in the energy production and trading businesses.
You're an oil producer. You have a certain proven developed production (PDP). You're long. If oil prices rise, you win. If they fall, you lose. A derivatives marketer has approached you with an interesting idea. With oil prices at $86, he can protect you against a price lower than $70. That sounds good, but the price of the $70 put does not. Always eager to help out, the marketer suggests that you fund the put by selling the right to any gains beyond $100 by selling the $100 call. The net cost of this hedging structure, called a collar, is zero.
The producer has locked in an outcome between $70 and $100. The exposure is hedged within a range. But there is no upfront cash flow from the hedging structure. Again, the marketer has a solution. If you simply add the sale of a $60 put to the structure, there is a positive upfront cash flow. So the absolute protection at $70 is replaced by protection over the range $70 - $60. There is no hedge below $60. But the producer "knows" the price won't go below $60 anyway. This kind of false knowledge is called "talking your book" in trading circles. In reality, the producer has hedged his production and speculated on a side bet by selling the $60 put.
If oil prices are range bound between $60 and $100, the producer will have made a "profit on hedging." Listen for that phrase. It's a clue that something is amiss. Hedges after all are offset by an underlying position. Yet there is no discussion of any loss on the underlying.
The last scenario involved selling the upside to fund insurance against the downside. What about simply selling the upside? Should that count as a hedge? Should a company protect itself against the "risk" of a large gain?
Chesapeake Energy, one of America's largest gas producers, thinks so. Over the past decade Chesapeake has recorded more than $5 billion in gains from selling nat gas calls. They are currently betting that prices will stay below $8 between 2013 and 2020. Jeff Mobley, Chesapeake's head of investor relations, notes that the company's hedging program has been highly successful during the last several years.
"If anything, the company would like to do more," said Mobley. This is understandable with NYMEX front-month prices just over $4 and 2020 trading under $7. The sentiment is familiar to any gambler who bet on red when the roulette ball lands on red.
Even the timing of a hedge can be speculative. If a producer arbitrarily decides when to put hedges in place based on when he sees "value" in the market, he is in fact speculating. Mike Corley notes that the firm's risk management policy must be the basis for a sound hedging strategy. The policy sets out what should be hedged and when. But very few producers actually have such a formal framework in place. So, instead of a reasonable policy that might call for 60% of PDP to be hedged on 24-month rolling basis, for instance, the firm puts a 2011 collar in place and reviews it when the mood hits them. Human nature being what it is, the mood often hits them after a big price move when they tend to make irrational decisions based on little more than their view of the market.
Speculative risks can be embedded in hedging transactions. Consider the issue of cash flow timing. Let's assume production has been hedged with a collar and the call is deeply in the money. If the expiration date of the call coincides with the end of production price risk, the call is payable two or three business days later, but the producer won't be paid on the actual production for 30 to 90 days after the product is delivered.
Imagine the producer who put a six-month hedge on in early 2008 with oil prices at $100. At expiration, oil was almost $150. The call seller would have been on the hook for a large cash payment long before being paid for the production.
Mike Corley also notes that "producers also tend to ignore basis risk." Let's say gas will be delivered at Mid-Continent. The hedge is done on the NYMEX which is for delivery at Henry Hub, in Louisiana. The producer sells a $5 swap. The future settles at $5.20 and the producer loses $.20 on the hedge. At the same time Mid-Continent trades down to $4.80. So effectively, the producer is selling for $4.60 ($4.80 - $.20) as a result of basis risk. $.40 was lost speculating on basis.
Things don't get any easier in a trading environment where a hedge may be distinguished from speculation by as little as the intent of the trader. The same objective set of actions, using the same instruments and with the same holding period may either be classified a cautious hedge or bold speculation. If you see wide latitude for interpretation here, you are not alone.
Let's say a trader buys a call on oil. Oil moves up, the value of the call increases, and he sells it. An open and shut case of speculation unless:
- The trader expected a customer to buy the call. He was simply accumulating inventory for sale to a customer. He was hedging his expected sale. The fact that the customer order never materialized or that the trader had the call offered well above the market, where no one would reach up to buy it, is quite beside the point.
- His portfolio was short oil. Buying a call is like going long oil. The degree to which this is true is called the delta. The positive delta of the call offsets, or hedges, the short oil position. The fact that the call introduced new risk elements like exposure to volatility, interest rates and time decay is incidental.
- His portfolio was short options. By going long this call, the trader was hedging the portfolio's exposure to market volatilities, called vega. He was also reducing the risk of losing money every time the portfolio is rebalanced, called negative gamma. In this explanation, the delta, probably the option's dominant risk element, is omitted.
- His portfolio was short another call, perhaps with a different strike or expiration. So the bought call creates a spread with lower risk characteristics. And the purchase was a hedge.
- Finally, his portfolio was long interest rates. As calls are worth less when interest rates rise, the call will tend to offset this exposure, marginally. Interest rates are only a minor risk element for options that expire within a couple of years. Left unsaid are the incremental and speculative exposures to delta, vega and time decay. This hedge justification couldn't be delivered with a straight face.
"The loopholes are big enough to drive a proprietary trading desk through," quipped Mark O'Toole, a commodities risk expert with OpenLink Financial, an ETRM software vendor. "The hedge/speculation determination can't be made looking at a trade in isolation. You have to understand the trade's incremental contribution to portfolio risk – the true benchmark – and you'll need a robust risk system to support that analysis."
The risk manager
So how can you reliably differentiate hedging from speculation? Well, given the nebulous differences and wide range of fig leaves available, asking is probably not the way to go. Too many roads lead to "hedge." VaR is a good proxy over time. Put simply, on days when VaR goes up, you probably speculated. On days when VaR goes down, you probably hedged.
VaR, which is typically run daily, will show the reality over time. But it doesn't provide a trade-by-trade accounting. If you want to be sure that all trades are hedges in a trading environment, the solution is draconian. Trade flat. Back-to-back everything. Maintain no position.
The trader starts with no position. So flat is an option. But that option doesn't exist for the producer with a natural long position. The producer avoids speculation by trading in strict accordance with a pre-defined hedging policy, so that discretion is removed from the equation.
When you come to the "hedge/speculation" fork in the road, take it!
Short of trading flat or perfectly hedging production in accordance with a well-defined risk policy, there is no practical way to verify the classification of transactions as hedges or speculation on a trade-by-trade basis.
There will be some uncertainty. A clear risk policy, a robust risk system, and a strong risk manager can help minimize classification problems. But hedging and speculation are fellow travelers, the Siamese twins of risk. Find one and you won't have to look too far to find the other.
About the author
Larry Hickey is a director with Sapient Global Markets who has written previously on energy trading and risk management for Oil & Gas Financial Journal. He has spent the past 13 years implementing industry-leading ETRM solutions. The rest is pure speculation.