Oil Volatility Cost Producers Hundreds Of Millions In Bad/Unusual Hedges

I’m about to open a small window into the arcane world of oil producers’ hedging. There are lots of industry terms you’ve never heard of…but the bottom line is this: Oil producers routinely write way out-of-the-money hedges and pocket a small premium on a situation they know will never happen – like oil under $20/b or $10/b.

But in March 2020 it did happen. And that has cost several producers tens or even hundreds of millions of dollars – being forced to sell their product at very low prices when a different kind of hedge could have saved them.

It’s the epitome of the saying–picking up pennies in front of a steamroller. Though to be fair, who saw this steamroller coming?

Until recently I never gave much thought to the type of hedge that an oil producer put on. Swaps, collars, puts, calls. Whatever. There was a fixed price, or a floor – and ceiling. That is all I needed to know.

But when oil started going way down – way, way, way down – I discovered that all hedges are not created equal. The problem child is something called a 3-way collar. This can best be termed as the fair-weather hedge.

A 3-way option is a hedge – as long as things don’t get too bad. If the bottom falls out, the 3-way option is really no hedge at all.

Trying to Pick Up Pennies In Front of a Steamroller

The first two parts of a 3-way option are the basic elements of any collar. The company buys a put – or an option to sell oil – at a price less than the price is on the day of the hedge. Then the company sells a call – or an option to buy oil – at a price above that the day of the hedge.

From this put/call spread the company is guaranteed a minimum price – that of the put they bought – and capped at a maximum price – that of the call.

Unfortunately, many oil companies wanted to squeeze some extra pennies out of their hedges – to bring the net premiums down. They realized that they were hedging a scenario that was extremely unlikely. That put they bought protected them again $40 and $50 oil, which made sense, but it also protected them again $30, $20 and $10 oil.

What were the chances oil would get that low?

So they layered on a third put, one that they sold, at a lower price then their spread. They received the cash for the put (ie. lowered the cost) in return for taking on that tail risk of an unlikely event that brought oil prices down to the $30’s or below. In the example below, this would leave the company unprotected (ie. exposed to lower oil prices) at anything below $40/bbl.

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