As part of our practice in risk management advisory, I’m often asked to help clients think about their risk management processes and compare those against their peers as a model of best practices. My first response is that while there may be a commonality in some of the ‘phrases’ or even tools deployed, the spectrum of approaches and results make it far more critical for the client to define what their desired ‘best’ outcomes are.
This isn’t just answering a question with a question in my best Socratic approach but an invitation to think about their earnings goals and, more importantly, defining ‘the story’ they want to ‘take to the street’ to describe their goals. My view is that the equity markets are still an open marketplace where ideas are competing for capital. This is a critical time for energy companies to be clear on that story when there are simultaneous calls for increased taxation on windfall profits and divestiture to make room for an energy transition.
The quarterly earnings season is a fantastic time to review the results and to hear the stories behind them. There is never a shortage of headline losses. And, in a quarter where benchmark crude and natural gas futures in the U.S. moved up 50% and 60%, respectively, the numbers from the ‘four-sigma move’ can be positively eye-watering. That leads to the additional headlines describing the decision to buy high after selling low by ‘unwinding’ hedges.
The descriptive statistics of market prices use volatility or sigma to describe the likelihood of certain price moves over time horizons. Crude is generally considered less volatile than natural gas and options change hands at an ‘implied volatility’ of around 30%. This means there is a consensus among participants that there is a better than 60% chance that prices will move less than a third (up or down) over the course of a year. A move as significant as we saw in Q1 of 2022 is four times that range because of how the math describes the relationship between time. A quarter is roughly half of an annual figure. In this case, the move is also double the single amount to get us to four. Over the quarter, the average price for these commodities was less volatile, with the moves only ~30%. Ignoring that this is also expected math from averaging and treating it as straight volatility that is still around a two standard deviation move. Many practitioners in the oil space will point to their use of average price swaps and options over the bullet instruments favored in gas and say that they are choosing to dampen their volatility exposure. That is a pretty fat tail in the distribution of returns; however, you’d like to think about that problem.
Since the first Saturday in May is approaching, I’m thinking about a different sort of tail, horse racing, and the Kentucky Derby in particular. The Derby is one of the great American sporting events, right alongside the Superbowl, the Indianapolis 500, and the Final Four. It’s an absolute spectacle to see 200,000 people gathered around. Because a large part of it also centers around gambling, it’s an excellent way to think about the nature of risk management and the relative value of winning and losing. There is no shortage of ‘systems,’ ‘tip-sheets,’ and ideas on how to approach betting the race. And there are certainly analogs in commodity markets to all of it.
My first thought on this relationship between horse racing and risk management is to give some perspective to that Greek letter phrase. In those terms, the long-shot now leading the race went out of the gate at 25,000-1. What would your reaction be if you’d bet the even-money favorite and saw that nag leading at the first pole? Would you tear up your ticket? Would you pay the lady in the large hat next to you holding the $2 ticket to win $50,000 on that horse $25,000 to split her potential winnings? Would you pay $10? Unwinding or paying to lift your hedges is exactly that sort of panic move at this point in the race. Even distorting the problem to use the averages as above, the odds on the long-shot bet went out to at least 100-1. Changing horses in the middle of the race is as bad an idea as paying $50 for half a ticket as it was at $25,000. Lesson Number One: Place your bets before the race and don’t try to make changes in the middle of the race. Build a plan and stick to it.
Next, let’s turn to the betting action in the owner’s boxes. XOM and BP each announced quarterly earnings this week. These are two of the largest fossil-fuel producers in the world. The former calmly identified a hedging loss of $700 million or roughly 12% of their unadjusted quarterly earnings, while the latter identified a ‘trading gain’ in their quarterly results. I’ll turn back to this part of the tale shortly. Let’s also unpack some of the other things the reports tell us. A large part of each presentation highlighted each company’s investments in the energy transition. The story they’re taking to the street isn’t just that fossil fuels are good, though there’s a measured dose of that view from each. The story they are telling us is that they see themselves as total ENERGY producers and not just OIL producers. It’s a classic lesson in risk management to point to the railroad companies of the 19th century or the steel companies in the 20th as failures for their lack of diversification. They defined themselves by their PRODUCT, looking inward rather than by their MARKET, looking outward. More often than not, the bets you see in this part of the park are betting the favorite first and then combining that choice with other horses in the field for a trifecta, a quad, or a parlay. It’s a way to get exposure to the long-shots without strictly betting them to win. If you place enough small bets around, many of these won’t pan out, but the right combinations can make up for it when things align. Lesson Number Two: A good plan starts with a focus on the business risks and diversification across products to address a market and not the other way around.
There was another commonality in the earnings report of these two favorites. There was a write-down for each due to their investments in Russian oil producers. Neither event was good. In the case of BP, it was a multiple of their quarterly earnings. Some will lament the size of the issue, complain that the decisions didn’t have to be made, or espouse that the boards were bowing to political pressure. I have a more measured reaction to these events. Political risk, the probability of a negative return resulting from a government decision or government instability and regime change, is a part of every business. Like hedging business risks, a popular approach to hedging political risk is straight diversification, but I think there is a more pointed lesson here. A segment of bettors at the track focuses on the trainers and the jockeys. That may not be the deciding factor in every race, but sometimes the person holding the reins can make a good decision or a poor one. Lesson Number Three: Align yourself with the leaders who make good decisions over time.
Finally, let’s return to the contribution to results from ‘hedging’ activity for these two big shops. I mentioned earlier that one posted a minor loss while the other posted a gain. Many would argue that these two entities are so large that they couldn’t possibly hedge 100% or are so diverse that additional hedging is unnecessary. While the management may see some truth in both of these statements, they continue to have a robust presence in the financial markets. Exxon’s hedging loss size and direction indicate that they were taking a little risk off the table when they hit price targets or focusing on hedging costs and locking returns of their investment program rather than their production. On the other hand, BP looks to have engaged in what we call a ‘Texas Hedge’ where they increase rather than decrease their exposure to market prices. In reality, I don’t think either outcome resulted from a single decision, hedge, or play but instead reflects a multitude of small choices. This Saturday, there will be a group of casual bettors at the park who, like me, will only pay attention to the track once a year or two. We recognize we don’t know everything about the track. So, we’ll make a few small bets, watch and try to learn how others are doing it. We’ll then adjust the way we’re playing from one race to the next based on what we learn. Lesson Number Four: Adjust the plan. Make small bets and many changes along the way, and learn from everyone around you.
Good luck out there this week. It’s quite a spectacle.
– Tom Aleman, Essentia Partner