Strategic Commodity Hedging

Commodities: blessing or curse?

Presence of the commodity is a blessing, yet can at times turn into the curse.  Countries that have significant proportion of their revenues streaming from a single commodity are at risk if inefficiencies, currency appreciation pressures, brain drain to the single commodity and above all financial instability.

While the policies designed at solving the first are on the supply side, and take years to implement, the strategy on the financial stability is somewhat more implementable in the short run.  Vision Finance has the expertise and knowledge to assist you with the establishment of such Commodity hedging strategy.

Commodity Hedging - the theory

Corporate economic theory states that the private commodity producers do not hedge the prices of their outputs as their investors want to have the exposure to the underlying price of the product. AN EXCEPTION to this rule is when the price of it is so low, reaching the cost of production levels, that the further deterioration of the prices could lead to the decrease in the stability of the company (its financial position, its cost of financing and refinancing).  The commodity producers hence often engage in long term hedges at the low prices that are just above the production cost, not with the aim of securing this price for the long time, but with the aim of ensuring its existence during the future times (when number of competitors can actually go out of business).  More on this can be read on commodity hedging page for corporates.

A similar logic applies to the sovereign hedging policies, though not being private, the governments are much more justified to engage into commodity hedging strategies.  Citizens are no shareholders, and while their long term wellbeing might be dependent on the price of the commodity, in the middle term they want the government to be able to provide its basic services and complete the already started projects.

In a way, there are three stages to the development of the Commodity Producers, particularly oil exporting countries.

stage 1:  new development, oil production, heavy infrastructure investment, no savings

stage 2:  steady oil stream, basic infrastructure in place, establishment of Sovereign Wealth Fund (SWF)

stage 3:  fully functional SWF, enabling the government to complete the started projects during volatile markets

For the governments that are still in stage 1 and stage 2, it is essential to hedge the already engaged projects, so that their cash flow is not at risk.  Similarly, it is advisable to hedge the non-elastic part of the budget expenditure, to ensure that even if the price of the commodity collapses, the government has enough revenue stream to provide the services it has engaged in.

Vision Finance has long experience at advising governments in establishment of such Strategic Hedging Programmes, including calculation of risks, exposures and optimal values of hedging. In addition,. Vision Finance  can assist the Sovereigns with the implementation of the strategy, including selection of hedging counterparties and negotiation of adequate credit terms that are either free of CSA (collateral support annexe), or designed in a way to eliminate the mark-to-market risk of the Sovereigns from sudden increase in the values of the asset.

Commodity Hedging - the practice

Vision Finance applies an empirical method in establishing the suitable oil hedging strategy.  With its state of the art financial models, it really is worth the analysis.

Below are the steps that we take:

1. analysis of the contracted capital expenditure, as well as government budget

2. calculation of the required hedge rate

3. selection of the most closely correlated and liquid hedging instrument

4. selection of the hedging strategy (puts / calls and hedging period): 

          a) purchase of outright puts at the required hedge rate

          b) purchase of outright puts, with the sale of the out of the money calls (zero-cost collar)

          c) engagement into the forward selling contracts, with natural oil consumers (brokerage)

5. design of the hedging strategy, calculation of costs and levels

          a) it is essential that the market is not expecting the hedge in order not to front run our decision

          b) it is essential that the selected arranger of the hedges, is selected by Vision Finance in order not to disclose the name of the client, avoiding the front running of the market (can cost as much as 30% of the hedge)

          c) VisionFiannce will also engage into the calculation of the adequate credit policy, ensuring that the CSA

                          - is delayed when Client is expected to pay (as it is right way risk)

                          - is immediately paid by the hedging counterparty (to hedge against wrong way risk)


Commodity Hedging - example of Mexico

Mexico is a country which is often used as example to show its prudent oil hedging strategy.  First the government calculates the minimum level at which the budget can be met, and then it purchases outright put options on 100% of its production in that budget year.  

It is calculated that the strategy costs Mexico approx USD1.5bn a year, or as analyst compare it USD 5 per each barrel of production.   This protects the budged, as for instance in 2007 Mexico hedged its production at the price of USD 70 per barrel , and prices reached as low as USD35 per barrel.

However in addition to direct financial benefits, it is worth nothing that:

     - Mexico obtains its windfall profits at the time when it needs them most

     - Mexico does not become an instant victim of higher financing costs and run on currency

The following interesting articles can be read on the Mexico Oil Hedging

Mexico and their oil hedging strategy

Mexico Hedged bought puts on 100% of its 2010 production at USD57 per barrel$57-per-barrel.html

Want to know more?  Contact Vision Finance.