Introduction
It’s easy to summarize why interest in commodities hedging has been on the rise recently: Huge volatility. Low liquidity.
On volatility – looking at oil markets this year, the number of times Brent has moved 5%+ or more in a single day has been about the highest in the last 30 years. The impact of these sharp moves has been felt by major consumers of oil – especially as very few U.S. airlines have had active hedging programs coming into 2022. Most of them shut down hedging operations after sector-wide losses in 2020, but they’ve been looking to reopen them since. In addition, there are brand new firms, especially across manufacturing and trucking, that are establishing new hedging programs to manage risk associated with the volatility. This all adds up to 2022 being the busiest period of consumer hedging that we’ve seen in years.
The benefits of systematic hedging are clear. For airlines that do hedge, their fuel costs are only up an average of 50% YoY, even though the market price of jet fuel has been up as much as 150% over the same period. In fact, companies like Southwest and Air France have each gained over $1bn from their fuel hedges.
On the other hand, oil producers have been active hedgers after 2020 when crude oil reached historic lows but have been closing out those hedges throughout 2022 to make sure they can catch any runup in prices. Further, commodity markets are facing a huge liquidity crisis due to a variety of reasons that we will expand on below. This combination of volatility and low liquidity has definitely posed a challenge for treasury desks with commodities exposures.
This article features a Q&A between Alison Fletcher, Treasury Market Specialist, and Dharrini Bala Gadiyaram, former head oil exotics / refined products trader and current head of enterprise risk at Bloomberg L.P., about the 5 Things New Commodities Hedgers Need to Know.
Should treasury desks hedge with over-the-counter (OTC) derivatives or exchange-listed futures and options?
OTC derivatives give hedgers much more opportunity for customization – whether it’s about zero-cost derivative structures, extendible swaps, deferred premium options or other hedges that are tailored for your balance sheet. On the other hand, low liquidity translates to higher margins from market makers, and using exchange-traded derivatives is a good way to minimize your execution cost.
There are additional considerations that come with exchange-traded instruments. The desk has to post and maintain margin, and exchanges define standardized maturity dates that may not necessarily line up with your exposure dates – this may cause an issue when applying hedge accounting standards.
What about liquidity across the term structure and the use of proxies in hedging?
In terms of liquidity across the term structure – as a general rule, upstream energy companies most often hedge two to three, sometimes even four or five years out. Oil and gas extraction is a capital-intensive exercise, and it’s important to maintain level cashflows for their business even through periods of high price volatility. In contrast, consumers rarely hedge more than one year out because they have alternate mechanisms such as fuel surcharges passed on to the consumer in case they are under-hedged in a high commodity price environment.
So, what is causing the current liquidity crisis in commodity markets? Over the past few months, macro investors have been pulling inflation hedges – especially commodity ETFs – as central banks began hiking rates. The scale of margin calls that we’ve seen from the immense volatility this year has also wiped out a lot of the available cash, especially in gas and power markets. A good metric for market liquidity is aggregate open interest across futures. The oil market is currently at around 60 percent of its high from the middle of 2021.
Under these circumstances, it’s good to have a few different diversified sources of liquidity and keep your mind open to proxies. That could mean hedging with benchmark contracts rather than those at specific delivery points that are better aligned with your exposure – you can close the differential between your hedges and exposures by trading basis swaps, which are often more liquid than fixed price swaps.
What are the derivative structures typically used for commodity hedging?
A lot of the derivative structures in commodity markets are borrowed from conventions in FX and rates derivatives. Each of the markets – oil, gas, power, metals, agricultural commodities – has a very different market dynamic, and the derivatives favored by the market can also vary depending on what the specific producers and consumers favor.
Typical hedging structures for oil, gas and refined products tend to be swaps, zero cost collars/three-way structures (call spreads combined with a put for consumers, or put spreads combined with a call for producers). Treasury desks typically prefer average-price swaps and options, which reduce the volatility of the hedge by minimizing the risk associated with pricing on any one day.
In agricultural commodity markets, especially grains, accumulators tend to be quite popular. They tend to perform well for producers in a high price and high volatility market.
What about the use of electronic trading?
Liquidity in commodity derivatives is still an order of magnitude lower than FX, so the market has been relative slow to adopt electronic trading for OTC derivatives. Hedging activity is predominantly allocated based on financing relationships across corporations and their market-making banks. However, any treasury desk trying to improve access to liquidity and lower execution costs must think about casting a wider net – potentially through electronic trading, sending RFQs across multiple dealers to diversify their options.
What about valuations and risk management on derivative structures?
The first consideration here should be making sure you have a risk system that can cover all the above: mark to market, hedge accounting, and credit valuation adjustments – all of the analytics required to meet accounting standards for the commodity derivatives.
A lot of hedging desks don’t focus much on day-to-day risk management since they plan to hold the hedges to maturity. But during periods of high volatility, using even a simple risk measure such as term structure delta will give you a better handle on day-to-day changes in MTM across your hedge book, especially for desks trading option structures. As your trading operations grow, using a good Value at Risk (VaR) model that captures the full-term structure and optionality can take your risk management to the next level and allow you to prepare for tail risk scenarios.
The bottom line
The most important consideration when implementing a hedging program is to be systematic – there may be years when hedges make money and years when they lose, but ultimately, it’s insurance. Allowing a hedging program to be swayed by price action is an easy way to fall into the trap of buying high and selling low. The best practice is hedging at least a targeted amount of your consumption or production every year irrespective of price action. It’s all about consistency!