Weighing Your Options Just Got Easier!

$10,000. Winner Takes All

Think you can trade? Prove it. Arc Capital Management is giving away $10,000 to a single winner in the Tournament of Champions, futures edition. Arc Capital Management is an Independent Introducing Broker providing institutional clients, professional traders and financial investors with the means to help you achieve your goals. Go here for details.

Producers and end-users, as well as their bankers and investors, don't want their companies to hedge away any of their upside potential, yet they also hate to see too much downside exposure, especially when the company is forced to compromise on its core strategy and lose ground to competitors. As an example, an end-user could end up accepting a high fixed price for its supply while its competitors enjoy lower prices in the marketplace. The end-user might experience cash flow constraints while its competitor is able to take advantage of acquisition opportunities to enhance its volume and profitability.

To choose the right strategy, a producer or end-user must carefully consider its current and potential risk in terms of how price fluctuations affect the bottom line. And, executives must have a good understanding of the costs inherent in each hedging technique. The judicious selection of a hedging strategy can improve return on gross invested capital and optimize the allocation of capital towards activities in which the corporation excels. In addition, a hedging strategy can facilitate predictable, stable earnings, smooth volatility, release capital formerly held against commodity price movements, guarantee earnings to support capital expenditures, and enable the corporation to maintain and expand its execution plan during adverse market movements.

THE WAY IT USED TO BE

• Abundant commodity trading shops and market-makers (financial houses, physical suppliers, crude oil and natural gas trading shops).
• High market liquidity and less volatility.
• More credit availability, based on financial statement review.
• Large market-makers willing to assume credit risk as another trading risk.
• Banks and financial houses more willing to support credit for hedging - for small and mid-sized producers and end-users.
• Competition among commodity derivatives dealers provided a "buyer’s market," facilitating easier hedging process, more transparent pricing, and more tolerance of small volume.
• More attention given to less sophisticated customers by dealers.

Then came October, 2001 and beyond, and the meltdown of Enron Corporation and the related tragic consequences to thousands of people and companies who dealt in good faith with a Fortune 500 counterparty, perceived to be a trusted market participant. The aftermath resulted in an international crisis of confidence in industry, as well as the public, which triggered government investigations of large, public companies and financial houses (analysts). Add the California power crisis and subsequent investigations, as well as false reporting to government agencies, by large energy merchant traders - the result was the exiting of trading and the closing, or significant reductions of trading floors for market-makers. Volatility soared, with less liquidity, and fewer hedging options were available. A significant amount of liquidity has been replaced by large hedge funds, but those funds pose systemic risks to the marketplace and can produce significant price volatility.

THE WAY IT IS TODAY

• Fewer hedging counterparties in the marketplace.
• Reluctance by existing hedging counterparties to deal with smaller volume.
• More scrutiny of financial houses and energy merchants by the public, as well as regulatory authorities.
• Across-the-board tightening of credit by banks and hedging counterparties.
• The days of substantial lines of credit for smaller producers and end-user companies are over.
• Producers and end-user companies are forced to post initial margin and assume variation margin risk with market movement.
• Large market-makers will only execute for larger and more sophisticated hedgers, and will not provide an education.

MAKING THE DECISION

Only the largest and most sophisticated companies can afford the luxury of a separate Risk Management department, or an experienced, in-house trader to properly evaluate commodity markets and design and implement a hedging program. For management to elect to not hedge at all, due to the complexities of the market, is the most risky and speculative approach that can be taken. So what is a company to do?

Choosing the right hedging structure.

1. How much price risk is the company willing to accept?
2. How much is the company willing to spend up-front and over time to hedge price risk?
3. What is the specific goal behind the company’s risk management strategy, and how does it fit into the company’s larger strategic goals?
4. What time horizon is to be used for all hedging activity?
5. What hedging instruments are considered an acceptable means for mitigating risk?
6. What are the appropriate risk limits for all hedging activity?

What options are available?

1. NYMEX/ ICE
   - Inflexible
   - High cash margin requirements
   - Trading experience?
2. Physical forwards
   - Typically expensive
   - May be able to forego margin requirements
3. Over-the-counter (OTC)
   - Hedges can be tailored -- very flexible
   - More market liquidity, especially in long-term options structures
   - Lower margin requirements, typically
   - Able to post letters-of-credit or tie to bank facilities
   - Easier to meet volumetric requirements

What do I need to know, and how do I execute an Over-the-Counter hedge?

1. In most cases, must execute a master swap agreement (ISDA).
2. In most cases, must meet volumetric requirements, in the case of large market-makers.
3. With major market-makers, executive giving execution order must know precisely how the structure works, whether bids or offers are fair market value, and whether fills are executed on a timely basis in a moving market.
4. Companies must monitor settlement methodology and pricing to ensure accurate settlement on counterparty statements.

How do I navigate the maze of risk management?

1. Self study.
2. Establish relationships with hedging counterparties who will be willing to guide you through the process and share market intelligence.
3. Hire a fee-based market professional to execute on your behalf, who has established relationships with major market-makers and extensive knowledge of commodity derivative instruments, to ensure accurate, timely, and cost-efficient fills.

SIMPLE HEDGE STRUCTURES

Swap (Fixed for Float Swap, or Fixed Price Swap):

A fixed-for-floating swap (Swap) is a privately negotiated, financially settled forward contract covering a series of forward price periods (e.g., Calendar 2008). A swap is designed to transfer or "swap" price risk between the swap purchaser (e.g., the End User) and the swap provider (OTC counterparty) through a contractual exchange of payments. It involves the payment of a fixed price time a notional quantity by one party, in exchange for a floating price times the notional quantity from another party.

A swap enables end-users to fix the purchase price of future consumption and thus minimize any exposure to rising prices. By locking in prices, producers gain control over the variable revenues and costs inherent in their businesses.

Since a swap is settled financially, there is no direct connection to the physical commodity, protecting customer/supplier relationships.

Caps and Floors:

Caps and floors are options which provide the right, but not the obligation, to enter into a long or short position at a specified price.

Caps, also referred to as "call options," establish a maximum purchase price for future consumption. They provide full protection from rising prices while allowing the buyer to benefit fully from decreases in prices. Caps are usually bought by end users.

Floors, also referred to as "put options," establish a minimum sale price for future production. They provide full protection from falling prices while allowing the buyer to benefit fully from increases in prices. Floors are usually bought by producers.

The buyer of the cap or floor agrees to pay a predetermined cash premium for the protection. The premium varies with the selected strike price, term of the contract, and length of the averaging period.

Caps and floors are usually financially settled based on the commodity price over a specified period. While long dated maturities are available, monthly and quarterly settlement periods are the most popular.

Collars:

A collar is a zero-cost or low-cost hedging strategy that provides a minimum and a maximum commodity price range for a specified period of time, for a specified notional quantity. As an example, for an end-user, the floor would represent the lowest cost of the commodity, and the cap would represent the highest price of the commodity. For a producer, the floor and cap would represent the minimum and maximum sales priced, respectively. For prices within the range, the hedger pays, or receives, market price.

Under a standard costless collar, there is no up-front premium payment. The producer or end-user will specify either the floor or cap price level (strike price) and the other strike price level will be calculated by the counterparty to ensure a zero-cost premium. Alternatively, both strike prices can be specified if the hedger is willing to pay some premium. In exchange for zero premiums, up front, the upside benefit of price moves is limited, as it is in a swap, but can outperform the swap by providing more upside benefit.

There are many more complex and exotic structures available to hedgers, but are beyond the scope of this discussion.

HEDGING IS NOT SPECULATION

Producers and consumers continually face the challenge of controlling their financial health and destiny, both of which are significantly impacted by volatile commodity markets. While many companies avoid the high risk of commodity trading, some are inherently exposed to trading risk as a by-product of their core business. For those companies that employ proper risk management techniques, the payoff can be huge during cyclical, or short-term market gyrations. Well-positioned companies can continue their core businesses and shop for acquisitions, while other competitors adversely affected by economic downturns due to price collapse are not able to focus on those same opportunities.

$10,000. Winner Takes All

Think you can trade? Prove it. Arc Capital Management is giving away $10,000 to a single winner in the Tournament of Champions, futures edition. Arc Capital Management is an Independent Introducing Broker providing institutional clients, professional traders and financial investors with the means to help you achieve your goals. Go here for details.