Oil market's volatility could mean lost revenue when hedging the wrong way

Dec 18, 2004 01:00 AM

by Lisa Sanders

While lofty crude oil prices handed oil companies their best year ever, oil executives should take a moments to thank those who frosted their cake in December -- the speculators.
With fund managers constantly on the prowl for lucrative plays, this fall investors and hapless consumers saw clear evidence that these managers pounced on commodities, spurring frenzy in the trading pits of New York and London.

Spot crude oil futures on the New York Mercantile Exchange, which started the year at $ 34.00 a barrel, surged to a record high $ 55.50 on Oct. 22, shortly before the US presidential election, then plunged 26 % to a post-election low of $ 40.70 on Dec. 10.
"The run-up was a combination of speculation and fundamentals," said Michael Lynch, president of Strategic Energy and Economic Research. "It's hard to quantify how much was fund buying, but it was definitely a big factor."

The funds held a mix of long and short positions with prices on the rise, but turned increasingly short -- betting prices would fall -- when oil topped $ 50 a barrel, Lynch explained, locking in profits and bolting from the market at the first sign of a downturn.
"Technical trading appears to be in the driver's seat, thriving on volatility and creating additional volatility," wrote Lori Schell, president of Empowered Energy, an energy consultancy firm, in an article about energy price volatility earlier. "It is important to remember that technical traders and speculators care not what the absolute price level is; their interest is in markets with high price volatility."

Hedge funds have the advantage of being able to move in and out of positions "in a heartbeat," said Tom Lord, president of Volatility Managers, a firm that advises clients on how to control the impact of volatile commodity markets on earnings.
"The movements (in price) have been faster and more volatile than the physical community can react to effectively," he said, drawing a distinction between futures traders, whotrade "paper barrels," and market players like refiners, who actually need the oil. "I see the hedge funds making a lot of money in the volatility and consumers and producers being whipsawed," Lord said.
After the US Energy Department reported a small decline in oil stocks, the January contract for crude jumped $ 2.37, or close to 6 %.

Fadel Gheit, an oil and gas analyst at Oppenheimer & Co., called the market's reaction to this news ridiculous. He argued that no less an authority than ExxonMobil Chairman Lee Raymond has said that oil is not in short supply and that fossil fuels will remain the world's primary energy sources through 2030.
In a recent television interview, Raymond said oil supply has been adequate for many months. The company constantly asks its refineries if they're getting all the crude they need, and they consistently say they are, he said. Gheit also believes supplies are sufficient, adding there was "nothing in the world that changed in the last 24 hours that would justify a $ 2 change in oil prices.
"And the reason they did is because of the speculators, he said. "Every large investment bank has huge exposure to energy futures," he said. "They are increasingly committing themselves to equity positions in oil contracts like never before. Traders want oil to be volatile. There is no reason for prices to drop 25 % in the last five weeks."

Gheit noted that OPEC's recent announcement that it would rein in about 1 mm bpd of oil production because it sees a glut in supply led to a jump in the price of crude. In the past, prices would have declined in response to such an announcement.
"I am absolutely convinced that the prices are being manipulated," he said. But there is no clear evidence to back his statement since Nymex, like any futures exchange, doesn't divulge who holds positions, how big the positions are, or whether they are net long -- betting prices will rise -- or net short, betting they will fall. Nymex reported that by Nov. 30 trading volume for its energy futures contracts had already set an annual record of 101 mm, easily surpassing the previous record of 94 mm traded in all of 2003.

The oil market's volatility could mean billions in lost revenue for the oil companies that hedge the wrong way.
"By and large oil companies do not win hedges," Gheit said. "The best they could hope for is to stay even. They are basically buying an insurance policy and it is an expensive one." But the biggest loser in all of this is the consumer, he said. "It's an additional tax on the economy."

Gheit pointed out that Amerada Hess has said it could forgo between $ 1 bn and $ 1.5 bn in revenue because it has 70 % of its production hedged. In its third-quarter earnings report, Amerada Hess said it had $ 1.05 bn of after-tax deferred hedge losses, realized and unrealised. Hedging costs reduced the company's exploration and production results by $ 180 mm in the third quarter and cut $ 377 mm from earnings in the first nine months.
Other oil companies have hedges in place to varying degrees. But that can add up to a lot of volume, Gheit said.

Kerr-McGee reminded investors it has hedged about 80 % of its expected fourth-quarter US oil volumes at an average West Texas Intermediate price of $ 28.54 a barrel. To date in the fourth quarter, Nymex prices for WTI have averaged about $ 49.20 a barrel.
A Kerr-McGee spokesman said its derivative program provides the company with "greater certainty regarding cash flow. Our derivative program is designed to underpin our expected capital and exploration program, our common dividend payment and our goals for debt reduction."
The spokesman said that the company believes its 2004 strategy has helped it achieve these goals. Not every company may be so fortunate.
"Are there people who are going to guess right? Yes, but it won't be the majority of the market," Volatility Managers' Lord said.

Source: MarketWatch
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