American Oil and Gas Reporter - June 2015 - 26

MARKETMATTERS
Crude Oil Price Rise
Sparks Producer Interest
In Hedging Strategies
Oil prices moved insistently higher from early April through
mid-May, despite evidence of bloated inventories and indifferent demand. West Texas Intermediate crude oil briefly topped
$62.50 before settling back, and distillate fuel oil prices added nearly 40 cents in the month.
The first reduction in crude oil stocks since the week ending
Jan. 2 was reported by the Energy Information Administration for
the week ending May 1. It was characterized by some as heralding the end of the supply glut, despite the reality that total petroleum
stocks rose 6.6 million barrels during that week. This raised the
question whether the April rally was likely to continue.
Arguing against that possibility was renewed interest by U.S.
oil producers in hedging production at prices seen as adequate to
ensure a profit and support new production. On a broader, geopolitical scale, hedging activity in the United States could counter
OPEC's idea that higher output and lower prices would inhibit
growth of non-OPEC production in America and other countries.
Hedging has the effect of fixing a price-in this case, a sales
price-for crude oil. Even if market prices for crude oil were to
fall, the hedger would be kept whole. Revenue from a lower sales
price is supplemented by gains realized from the hedge.
The simplest producer hedge is the short sale of futures contracts. The futures contract is sold for a particular time and price,
say December 2016 at $64.39. If prices fall during the life of the
contract, the seller can buy the contact back and use the proceeds
to offset reduced revenues from the sale of physical oil. However,
the price fixed by the sale also limits gains realized from crude
oil prices advancing further than the hedge.
One way to overcome the problem of limiting upside gains is
to purchase a put option. A put option gives the owner the right,
but not the obligation, to buy the option back. If prices rise, the
put option will lose value, but the producer is not required to buy
at the higher price. The objection to buying options is their cost.
A third strategy available to the producer is to buy a put with
a strike price below the market and pay for it by selling a call option. Selling the call option at a strike price above the market price
provides revenue to pay for the put. It also limits benefitting from
market prices higher than the strike of the call sold, but the producer can at least participate in some market price gains.
Purchasing a put and selling a call is called a "collar." Press
sources have reported, for example, on a $45/$70 collar structure.
As of mid-May, WTI crude oil was trading slightly below $60.
This strategy means the producer accepts the market price between
$45 and $70. $45 represents the lowest price the producer should
receive for output and $70 is the maximum point at which revenues are capped.
In some cases, an additional put has been sold at a strike price
below that of the put purchased-$45 in this example. This brings
in additional revenue to pay for the put. The hedge protection afforded by the put runs out if prices really tumble below the strike
Transactions in securities futures, commodity and index futures, and options carry a degree of risk. Past
performance may not be indicative of future results. This column is for informational purposes only. It does
not represent an investment offer, solicitation or recommendation.

26 THE AMERICAN OIL & GAS REPORTER

" The rally in crude oil prices this year
opens the possibility of establishing
protection at remunerative levels.

price of the sold put.
The rally in crude oil prices this year opens the possibility of
establishing protection at remunerative levels. It also could presage
new production and renewed downward pressure on prices. Seasonal factors could play into that situation, with prices falling before the start of autumn when demand for distillate fuels, in particular, could rally prices again.
U.S. producers are reportedly protected this year about half
as much as they were last year. Current prices make it possible
to redress that shortfall. Price volatility, which is a major component of the cost of an option, has been falling, adding to the
attraction of hedging. The Chicago Board Options Exchange crude
oil volatility index has fallen to 35 from a four-year high of 64
reached earlier this year.
❒

ALAN H. LEVINE is chairman
and chief executive officer of
Powerhouse, a registered affiliate
of Coquest Inc., and a commodities
brokerage offering hedging services to the energy industries.
Levine has more than four
decades of experience as a petroleum specialist. He may be
reached at alan@powerhouseTL.com or 202-333-5380.

American Oil and Gas Reporter - June 2015

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