HEDGING RATIONALE AND CONSIDERATIONS
The outcome of a commodity finance loan is highly dependent on the underlying commodity price before and after drawdown. We mentioned in our Acquisition Finance article that lenders design such loans based on the obligors’ cash flows available for debt service (“CFADS”) – commodity prices are a significant driver of predictability and stability of CFADS particularly for projects that have sticky fixed costs with little ability to flex cash costs downwards in a low price environment. Given their inherent exposure to commodity price risk, it is commonplace for commodity finance lenders – especially lenders participating in mid-to-long loans – to require sufficient commodity price hedging to ensure the recovery of principal under all price scenarios.
Depending on the hedging strategy employed, some hedging programmes require upfront costs, which need to be factored into facility uses of proceeds, especially for obligors that do not have a strong credit standing in international debt markets.
HOW DO LENDERS ASSESS REQUIRED PUT STRIKE PRICE?
Caravel Capital was involved in conducting a commodity price hedging analysis for a lender to an independent upstream E&P producer, where buying Put options (“Puts”) allowed loan facility to benefit from downside protection on the revenue receipts linked to Dated Brent Crude Oil (“Brent”). The objective was to buy (or long) Puts at a strike price that would result in the recovery of principal under all Brent price scenarios.
3-step process to determine the required strike price:
- Step 1: Determine the base case upon which the hedging analysis would be performed on, including cost assumptions from operating expenses, capital expenses, taxes, royalties, government take, abandonment provisions (“Abex”), etc. – refer to our Financial Modelling Services and Evaluating Project Economics article for the key components of a robust set of base case assumptions
- Step 2: Determine the duration of hedging required, which typically involves understanding the lender’s desired loan duration and CFADS profile. In determining the final maturity date of a loan, lenders consider a myriad of signposts, including when the project CFADS starts decreasing exponentially, obligors’ large debt service obligations on other loan facilities, when reserves reach approx. 25-30% of the initial recoverable reserves, etc.
- Step 3: Determine the required strike price by triangulating to the flat commodity price required for the project to breakeven on an unhedged basis during the hedging period ascertained in Step 2 (i.e., CFADS over the hedging period plus minimum cash reserve and balances in the debt service reserve account (“DSRA”) not funded by CFADS equals zero)
A reasonable hedging analysis would also take into account other practicalities which may translate to high hedging costs. For instance, liquidity tends to thin out when locking in hedges that are for longer than 24 months. Clearly, hedging costs also become expensive when the required strike price levels are set at a slight discount to the prevailing swap reference price.
HOW DO LENDERS ASSESS REQUIRED HEDGING VOLUMES?
Our approach to evaluating the required hedging volumes, for a long Puts strategy, is to consider the total required dollar amount from hedging against the per unit hedging margins. Assume the following:
- Facility amount: US$50MM
- Minimum cash reserve: US$8MM
- DSRA: US$2MM
- Required put strike: US$60/bbl flat (investment breakeven)
- Project all-in costs: US$40/bbl (asset breakeven)
- Production over hedge period: 2.5MMbbls
3-step process to determine hedging volumes:
- Step 1: Determine the dollar amount of hedging payoffs required (e.g., US$50MM principal less US$8MM minimum cash reserve less US$2MM DSRA equals US$40MM payoff required)
- Step 2: Determine the unit margin based on the required put strike level (e.g., US$60/bbl required price level less US$40/bbl project costs equals US$20/bbl)
- Step 3: Calculating the required hedging volumes (e.g., US$40MM required hedging payoff divided by US$20/bbl margin equals 2.0MMbbl i.e. 80% volume to be hedged)
A keen understanding of the chosen hedging instruments is critical in designing a workable hedging strategy. As the outcome of a hedging programme depends on both the strike price and hedging volumes, the analysis needs to consider both aspects contemporaneously.
Using the same example above and keeping in mind that long Puts have a zero payoff when the underlying commodity price is above the strike price, a useful approach is to set the strike price at the investment breakeven level (US$60/bbl in the example) before determining the required hedging volumes. This stems from the observation that any lower strike price would result in a CFADS (including hedging payoff) that falls below the loan principal amount, even if fully or over-hedged, whereas the required hedging volumes start to fall when considering strike prices at or above the investment breakeven level.
Lenders will require obligors to grant security over the collection account where the hedging proceeds are to be directed. Costs relating to the maintenance of the chosen hedging programme would commonly be an item in the cash waterfall assigned to the collection account. Hedging transactions are required to be documented in a separate ISDA documentation which may also take time to put in place with the hedge provider.
Further, lenders typically require pari-passu status with the senior lenders and would likely request for inter-creditor arrangements to outline where hedging proceeds and security sit amongst the rights of multiple tranches of creditors.
OTHER COMMON HEDGING ARRANGEMENTS
While we have only discussed the long Puts strategy in the above example, these are several other common hedging arrangements used in commodity finance transactions:
Bear Put Spreads
Price downside protection limited to when price levels are between the two strike prices, naked exposure below the lower strike price – this is achieved by
- Buying Puts at a higher strike price; and
- Selling Puts at a lower strike price
Fixed and Floating Swaps
Exchange floating price for flat floor price payoff, which creates negative payoff risks to the lender when the underlying prices move above the floor price – this is achieved by entering into a swap arrangement with a hedge provider (typically a financial institution)
Zero-Cost (or Costless) Collars
Price downside protection below the Put strike price and price upside capped at the Call strike price, where the premium paid for the Put option is offset with premium received by selling the Call option – this is achieved by
- Selling Calls at a higher strike price; and
- Buying Puts at a lower strike price
Price downside protection limited to when price levels are between the two Put strikes and price upside is capped when price levels are between the two Call strikes, where premiums received from the Bear Call Spread offset premiums paid for the Bear Put Spread and is achieved by
- Bear Call Spread – Buying Calls at $70/bbl and selling Calls at $60/bbl (exposed to negative payoff up to ($10/bbl) when prices are > $60/bbl); and
- Bear Put Spread – Buying Puts at $40/bbl and selling Puts at $30/bbl (receive positive payoff up to $10/bbl when prices are < $40/bbl)