E&P Hedging During the Price Downturn: Risk Management or Financing Activities? 1
By Rob Purdy, Shane Randolph & Matt Smith, Opportune LLPUpstream companies are experiencing liquidity strains due to recent energy price declines. While a recent industry study noted that the majority of upstream companies maintain a hedging program, many of their hedges have expired or will in coming months. Exploration and production companies operate in a capital-intensive industry. Drilling for oil and gas requires large amounts of cash, and companies must find ways to raise capital to meet their needs. Most have an established revolving credit facility, and access to this credit is dependent upon maintaining debt covenant compliance. The agreements frequently stipulate that substantial amounts of production must be hedged to protect against price declines. Over the past 6 months, upstream companies have utilized more creative hedge strategies to generate cash for the near term. Management teams are hoping that the combination of the earnings from these hedges and revenue from crude production sales will keep them in compliance with their debt covenants in this difficult market.
The decision to hedge production in the current low-price environment certainly isn’t easy. Traditional swap agreements do an excellent job of protecting against further declines, but locking in prices at recent levels may not meet current liquidity requirements to maintain operations or meet debt covenants. Purchased puts retain all production price optionality in the event prices retrace higher from recent lows, but with heightened market volatility, the premiums are often cost prohibitive for cash strapped companies. With depressed energy prices, the majority of hedge strategies traditionally deployed by producers are perceived as flawed, too expensive, or just plain tough to swallow. There are alternatives that present limited risk and result in more favorable near-term hedge pricing. One such strategy is what some are calling an “Enhanced Swap.”
For the purposes of this discussion, an Enhanced Swap is where a producer sells out a calendar strip of call options against a portion of forecasted future production in order to receive favorable pricing on a near term swap. The proceeds from the sale of the calls are aggregated and utilized to secure a higher near-term price in a fixed for floating swap. There are a couple of current market conditions that make this strategy more viable than in days past. For one, energy markets are enjoying a long stretch of historically high volatility. Simply put, increased market volatility results in higher option prices. In similar fashion, this increased volatility is to blame for the common view that outright purchased puts are cost prohibitive. The second major factor revolves around the forward curve structure. WTI has been in a long cycle of market contango, with underlying prices increasing as we look further out on the forward curve. The relative values of calls increase not just as a function of time to settlement and market volatility, but also with the price of the underlying instrument. Again, the end result is higher pricing, which amounts to increased “bang for the buck.” This allows a producer to sell a smaller relative portion of future production and obtain a greater percentage of present day hedge coverage.
Let’s assume that a producer has operations totaling production of 1,000 bbl/d. The company currently has no hedges in place and is reluctant to lock in prices at current levels. Management determined that by selling calls for years 2017 and 2018 at $55/bbl against 20% of forecasted production, they could obtain an Enhanced Swap price $9.66/bbl above current market pricing for coverage on 20% of 2016 production. While they are faced with sacrificing cash flows at oil prices above $55/bbl in 2017 and 2018, they retain the optionality on 80% of future production and obtain 2016 hedge pricing that strengthens their position in the market.
While there is the perceived tradeoff of locking-in less desirable prices in the future in order to obtain favorable prices today, a dynamic approach to hedge portfolio management increases the chance to retain production optionality in 2017 and 2018. What makes this dynamic approach so attractive is that in many situations, the producer can recover the opportunity cost without significant outflow of cash. Two strategies enable this to occur. First, the short call positions can be purchased back either from the initial counterparty, or as offsetting positions with a separate counterparty. Second, the short calls can be “rolled up” by way of initiating a long call spread position. The producer repurchases the short calls and establishes a new position at a higher price, effectively increasing optionality from $55 up to the new price.
There are a couple of general behaviors with options that increase the likelihood of these scenarios unfolding – even in the event of rising oil prices. For one, an option’s value is largely a function of time and uncertainty (volatility); thus all options are decaying assets. While there is no crystal ball when it comes to forecasting future energy prices, the general consensus of leading economists is that prices are in for a slow recovery. This leads to the second generalization that uncertainty (volatility) has a tendency to decrease alongside slow, increasing underlying prices. With decreased time to settlement and lower volatility, come cheaper option premiums. In the unlikely event oil prices move sharply higher in a short amount of time, the producer that executed the Enhanced Swaps won’t likely have the opportunity to cover short call positions. However, with only 20% of 2017-2018 production locked in at $55/bbl, the increase in cash flows from the remaining 80% of production would far offset the lost opportunity.
It is important to know that there may be financial reporting implications associated with the Enhanced Swap hedging strategy. The default accounting treatment for a derivative is to record the fair value on the balance sheet at each reporting period with the changes in fair value recorded in earnings in the period of change. While the strategy discussed above seems more convoluted, the accounting remains the same when hedge accounting is not applied. The in-the-money sold swap and the sold calls are recorded to the balance sheet at fair value each reporting period with the changes flowing through earnings. However, there are some other reporting issues to consider. The two most contentious issues relate to statement of cash flows presentation and timing of recognition in a company’s non-GAAP financial measures.
Companies will need to consider if the cash flows of the derivatives should be classified as a financing activity. ASC 230-10-45-27 states, “If the derivative instrument includes an other-than-insignificant financing element at inception, all cash inflows and outflows of the derivative instrument shall be considered cash flows from financing activities by the borrower.” Generally exploration and production companies will include cash flows from derivative activities in either investing or operating activities on their statement of cash flows. It is rare that a derivative’s cash flows would be included in financing activities. However, at the execution of the hedging strategy the expectation is that the company will receive cash flows in 2016 from their in-the-money swap.
This leaves most companies with the question of how to determine whether or not the derivative instruments executed in this hedging strategy include an other-than-insignificant financing element. With ASC 230-10-45-27, the FASB was attempting to avoid the possibility that a derivative would be used to hide a borrowing and thus not reflect the true nature of a liability in the financial statements by masking it in an instrument accounted for at fair value. Contracts that are designed to ensure cash inflows for one party in the early periods followed by cash outflows to the other party in later years often contain a financing element. While at inception it is anticipated that the company will receive cash in 2016, it is not ensured. Further, there is uncertainty as to whether any cash will be required to be paid out as the sold calls settle in 2017 and 2018. For this reason, it could be argued that the derivative instruments executed in this strategy do not contain a financing element.
The use of this hedging strategy could also cause companies to reconsider what is included in their non-GAAP financial measures from a derivative standpoint. Exploration and Production companies often disclose non-GAAP financial measures to their investors. These are required to be shown in reconciliation format to the most comparable GAAP measure, generally net income or operating cash flows. For most measures of performance, a company will start with net income, and from that, deduct interest expense, taxes, depreciation, amortization (“EBITDA”). Within this reconciliation, companies generally make adjustments for other items as well (“Adjusted EBITDA”, “EBITDAX”, etc.). A common adjustment for exploration and production companies is to remove gains and losses associated with the changes in fair value of their derivative positions, leaving realized settlements only.
In 2013, exploration and production companies were bombarded by the SEC with comments on the appropriateness of derivative activity included in their non-GAAP performance measures. One common theme from the SEC was that registrants should clarify their adjustments for current period settlements of derivative contracts. This comment was problematic for some companies using purchased put options to hedge their production. For this strategy, the company would pay a premium at inception for purchasing a put option.
At settlement, the company was including the full amount of cash received in their non-GAAP performance measures even if a portion of those settlements represented a recovery of the initial premium paid for the put option. For example, a company paid $3 for a $90 floor to hedge its crude production. If the price settled at $85, the Company received $5 at settlement. Some companies included the full $5 settlement amount in their non-GAAP performance measures. This presents an issue in that the cumulative gain on this instrument under GAAP was only $2 (the $5 received at settlement less the $3 premium initially paid to acquire the put option). The SEC has made it clear through the comment letter process that this was not appropriate for a non-GAAP performance measure.
A frequent statement included within these comment letters was that derivative settlement amounts recognized in non-GAAP performance measures should be limited to the cumulative gain or loss reported since the derivatives were acquired. No portion of amounts recognized in non-GAAP performance measures should represent a recovery of cost (e.g. recovery of the premium that was paid for the derivative instrument). This leaves the question of whether it would be appropriate for a company to include the full amount of cash settlements from their 2016 Enhanced Swap in their 2016 non-GAAP performance measures. Alternatively, should the company deduct from the 2016 swap settlements the stated or implied premium amounts and defer recognition of these amounts in their non-GAAP performance measures until 2017 and 2018 as the sold calls settle? "
These are questions a company must consider when evaluating the impact of this hedging strategy on their non-GAAP financial measures. Whether a company’s non-GAAP financial measure is a measure of performance or a measure of liquidity will play a large role in determining the appropriate amounts to include in the measurement. A company is required to disclose the reasons why management believes the presentation of a non-GAAP financial measure provides useful information to investors, which will certainly play into the decision of how management will include these items in their non-GAAP measures. One thing is for certain. The SEC’s Regulation G provides a general disclosure requirement that a registrant shall not make public a non-GAAP financial measure that is misleading. That being said, whatever the company decides needs to be adequately disclosed and consistent with the disclosed purpose of the non-GAAP financial measure.
Management teams should review the strategy closely and discuss future commercial implications and financial reporting ramifications of any applicable hedging strategy. Opportune utilizes its deep energy experience to help producers with the full lifecycle of their hedging programs. Our experts examine the specific factors at play and provide a comprehensive view to management. Our strategic methodology is designed to support our clients’ particular business objectives, including driving results while meeting transactional standards.