Billion-dollar fuel-hedging losses offer a counterintuitive lesson for corporates.
If you are a company that buys a lot of raw materials, you are probably wishing the current prices for oil, metals and grains could last forever. You cannot change or predict what the market will do, but you can take a step in that direction by hedging—contracting to buy or sell a certain commodity at a fixed price in the future.
Many firms feel the pressure of market volatility. In the latest Global Capital Confidence Barometer from consultants EY, commodity and currency volatility ran a close second to political instability as respondents’ greatest short-term business anxiety.
A HEDGE IS NOT A BET
Hedging, however, can be more complicated and expensive than it looks. Prices can move in either direction even from what looks like an historic low. When oil prices slid from $120 to $50 a barrel in the autumn of 2014, several companies made expensive mistakes that have become the stuff of legend among the tight-knit hedging community. Delta, United Continental and Southwest Airlines all locked in jet fuel purchases at prices they thought would be the market bottom, spurring billions of dollars in losses when crude fell still further. Oil producer Anadarko forced itself to buy oil at $80 as part of a web of hedges that were meant to offset each other but didn’t. American Airlines, the biggest US carrier, swore off hedging entirely after the 2014 oil collapse. “Hedging is a rigged game that enriches Wall Street,” company president Scott Kirby complained to the media at the time.
The hedging pros draw a less categorical, somewhat counterintuitive lesson from these blunders: A hedge should never be a bet on markets. “No one can predict where prices will go,” says Mark Smith, a partner in PwC’s Houston office. “Even speculative traders work on differentials between various prices. They don’t try to predict.”
The proper goal of a hedging program is to smooth out bumps in cash flow and profit over time by decreasing the volatility of one key cost component. “Good companies don’t focus on, ‘Hey, prices are low today.’ They focus on, ‘I don’t want more than a 5% shift in earnings,’” says Talib Dhanji, commodities markets leader at EY. This approach requires patience at points when hedges are out of the money [i.e. the strike price of a call option is above the market price or the strike price of a put is below the market price] and fortitude in facing irate shareholders. But the approach pays off in the long term. Southwest Airlines treasurer Chris Monroe estimates the airline saved $2 billion on its fuel hedges between 2001 and 2015, saving more as prices rose pre-2008 than it lost in the recent meltdown. Southwest has earned a reputation for steady profitability that has propelled its shares to outperform most peers.
DOUBLING DOWN: THE HEDGE HEDGE
To make hedging pay over a somewhat shorter term, companies might hedge their hedge, restricting future price unknowns to a relatively narrow band. As a rough example, with crude oil priced around $45 a barrel, an airline, utility or oil refinery might buy call options insuring it the right to purchase at $55. Because that insurance is expensive, it could offset the cost by selling put options at $40—obligating it to buy from an oil producer, should prices dip that low. The fuel consumer effectively restricts future costs to a $15-a-barrel band, at least for the quantity and term covered by the hedges, while the premiums on the options bought and sold more or less offset each other. This is a classic strategy known to traders as a costless collar.
But this collar isn’t costless for companies intending to hold the options for years and actually buy the underlying product, says Steve Sinos, vice president at Mercatus Energy Advisors in Oklahoma City. “Costless does not mean free,” he says.
The reason for this contradiction is margin. Like stock purchases, futures contracts purchases require cash collateral, around 7.5% for a standard exchange-traded product. Companies can face sudden demands for more capital that may come as a shock to executives outside the CFO’s office who were counting on deploying that capital. “If I’m running a company, I have no time for putting up $500 million in collateral,” EY’s Dhanji says.
Despite these disclaimers, hedging can be appropriate and even essential, depending on your company’s commodity dependence. That may be more or less than a simple percentage of expenditure. “It’s essential to calculate actual risk exposure,” PwC’s Smith says. “If you use natural gas as a fuel, can you pass the costs on? If your competitors are equally exposed, then you could argue that your own price exposure is minimal.”
If you opt for hedging, it needs to become a strategic function, with a long-term strategy signed off on by the CEO and the board, and specialist staff to watch over it. A CFO dabbling based on reactions to market momentum is a prescription for disaster. “If I liquidate the hedge when the market turns against it, it doesn’t erase the loss,” Smith points out.
Buy and hold won’t quite work for hedging either, though, as the underlying futures contracts have finite terms, usually from two to four years. That means steady rollover, and an opportunity to recalibrate the hedging bets based on market conditions—an opportunity hedgers should not overlook. “Among the other common mistakes, you have to list ‘set it and forget it,’” says Mercatus’s Sinos.
Be prepared as well to hire an extra bean counter or two. Hedging strategy may not be that complicated, but hedging accounting is, and post-2008 regulatory c.hange is making it more so. The US Dodd Frank law promised to place new disclosure and clearing requirements on a range of commodities futures. Washington has not written the concrete regulations yet, but presumably will do so during the next administration. “Hedge accounting rules are complex,” Talib Dhanji says. “If you can’t apply the accounting properly, you shouldn’t be hedging.”
The good news is that the supply of potential counterparties and advisers for hedging has expanded since the financial crisis. Physical petroleum traders like Glencore and Vitol and diversified merchants like Cargill have moved into a financial arena formerly dominated by a few investment banks, and players on all sides of the trade are getting smarter. “Five years ago energy traders could go to a utility and sell a contract that was extremely profitable,” Dhanji says. “Now utilities are hiring consultants to bargain on their behalf. The key is to have internal capability.”
Now could well be the time to build that capability. With oil and copper prices both near seven-year lows, there should be nowhere to go but up. Or should there? Make sure to check with a professional first.