Energy Hedging, Part I

An energy market participant can hedge using exchange-traded or over-the-counter (OTC) derivatives, long-term contracts, supply diversification strategies, or specialty insurance.  Exchange-traded derivatives include futures, options on futures, and swaps of futures contracts:

•  Natural gas futures, options, swaps, and basis swaps

Futures and options can be combined in innumerable ways to create a suitable hedge for a particular company’s situation and risk tolerance.  For example, if you had a need to purchase natural gas next month, but were concerned that the price might be high at that point, you could buy gas options now in addition to buying the actual gas in one month – the net cost of the gas to you would be capped at the strike price (i.e. the pre-set exercise price) of your options.   Alternatively, you could buy futures, which would fix the cost of gas to you absolutely, saving you money if prices go up, but resulting in an opportunity cost of overpaying if prices decline.  Aswap, in turn, locks in an effectively fixed price for a future purchase by “swapping” the floating price risk for a fixed price from the counterparty.  We have illustrated several of the most common energy commodity hedging strategies in Figure 1.7.

In order to make an impression on higher-ups in the energy world, it’s imperative that you grasp the issues that “keep them awake at night”:  Where are oil prices going over the long term?  Are we running out of oil?  How might pollution regulations change?  Should I consider a potential carbon tax in my decision-making?  Will changing regulatory rules of the game affect

my business? 

The answer to each of these questions can have a profound impact on a company’s business strategy and profitability.  Below are four issues that will give you a sense of the key industry topics you’ll need to familiarize yourself with for interviews.

Oil Supplies

There is, by definition, a finite amount of oil in the earth.  We will eventually run out of it.  What is at question is when it will happen, and whether we will have enough advance warning to adapt.  On one side of the debate, a variety of constituencies are concerned about the social and economic consequences of oil wells running dry, and are also interested in the environmental benefits of a transition to renewable sources of energy happening sooner rather than later.  Aproliferation of books with titles like The End of Cheap Oil, Out of Gas, and The Party’s Over make that case passionately.  On the other hand, incumbent oil interests are naturally optimistic about their own ability to find and extract oil, and tend to resist the argument that alternatives to their main product are in urgent need.  Both sides of the debate do tend to agree that oil

prices will shoot up when global production starts to permanently decline; estimates for when that will happen range from this year to 2100.

So, how much oil do we have left?  One of the reasons this issue is so contentious is that oil supply is very difficult to measure.  Oil supplies are categorized as follows:
•  Undiscovered oil
•  Possible reserves (discovered, with less than a 50% chance of being recovered)
•  Probable reserves (discovered with greater than a 50% chance of being recovered)

•  Proven reserves (recoverable)

Proven reserves are often overstated, as producers have every incentive to self-report a greater amount of wealth to their shareholders and lenders.  Shell restated its proven reserves downward by 20% in early 2004, for example. OPEC countries have been in a “quota war” since the early 1990s, ratcheting their proven reserve statements up by impossible jumps of 50% at a time, in order to be allotted larger production quotas.  Estimates of supply currently hover around 1 trillion barrels of proven reserves and some 2 trillion more ultimately recoverable out of probable, possible, and yet-to-be-found deposits.  Contrast that with 30 billion barrels in exponentially accelerating annual worldwide consumption and, taking supply uncertainty into account, the problem quickly becomes apparent. 

And what does an oil-less future look like?  That depends how far distant that future is.  In the near term, transportation can run off of natural gas (which is also finite, but substantially less depleted than oil), or electricity.  Electricity can be generated by natural gas and coal, which by most accounts still exists in large enough quantities to fuel our society for a couple hundred years.  In the longer term, we can envision the environmentalists’dream of a “hydrogen economy,” in which renewable energy splits water molecules apart, and the resulting hydrogen powers efficient, zero-emission fuel cells. 

Most oil companies have been investing in oil-substitute technologies since the mid-1990s (consider BP’s “Beyond Petroleum” slogan, for example). Most of them also publish long-term forecasts of world energy consumption that show oil declining in importance over time relative to other current energy sources – those forecasts, however, tend to show a disturbingly substantial segment of future energy demand met by an unknown source labeled “surprise” or “future discoveries.”

Conventional economic wisdom suggests that when oil supplies begin to wane, prices will rise, and demand will fall in response, thus extending the life of the remaining supplies.  Rising prices would make technological innovation profitable, improving our ability to extract oil from small and remote deposits previously thought unrecoverable.  Adherents to such a

theory point to the oil shocks of the late 1970s, which motivated radically reduced consumption and investments in renewable energy technologies.

However, those who are concerned about an imminent oil shortage point out that the theoretical macroeconomic refrain “demand will fall” belies a lot of microeconomic pain and disruption.  When oil prices increase, the cost of most everything one can buy increases, which forces us to consume less, accept fewer consumption choices, and make difficult lifestyle sacrifices. Rising oil prices slow the economy, drive down employment, and lower standards of living.  So, just because the market will, at a high level, “adjust,” doesn’t mean that dwindling oil supply is not a crisis-level problem. Discovery of new oil fields peaked back in the 1960s, and oil production peaked for many countries (including the U.S.) as long ago as the 1970s.  The fundamental question is: will we know with enough certainty far enough ahead of time to make the market “adjustment” a gentle one?  And if not, doesn’t it behoove us to start that transition now?