HEDGE STRATEGY EFFECTIVENESS

Client: Midstream Natural Gas Processor

 

Problem: Crude oil and natural gas hedges used to hedge NGLs (aka a cross-commodity or proxy hedge) suffered financial losses at settlement. Senior management was concerned that these hedges were ineffective and resulted in unnecessary losses. An assessment was requested comparing pro forma results for a traditional hedge program where the NGLs would have been hedged directly, using NGL swaps and collars.

 

Solution: R^2 modeled two different portfolios using direct hedges chosen by management for the comparative analysis. These strategies used financial instruments that matched the commodities, volumes and hedge dates used in the client’s portfolio. Historical price curves and volatility surfaces were used to create the pro forma results.

 

Results: The pro forma analysis demonstrated that the hedge strategy used by the client was indeed the most effective. It was determined that on each of the hedge dates, the NGL forward curves were more discounted (backwardated) than the curves of the chosen hedge instruments. These discounts would have impaired the effectiveness of the direct hedges, increasing the cost of hedging to the client by ~$2M to $5M. In addition, conventional hedges would be subject to increased slippage because the NGL market is less liquid. This would have cost the client approximately $1M more.

 

Conclusion: Though the selected proxy hedges were unprofitable, they outperformed the direct hedge strategies identified by management. R^2 assists clients in the selection of hedge instruments, attempting to identify the best strategy at the time of execution. We utilize our extensive data base and analytical tools to review historical pricing patterns and relationships to provide a statistically sound framework from which hedge strategies can be evaluated before selection. The same database was used in this case to model and back-test various strategies to provide management with a thorough performance review.