Cash Flow Maximizing Tactics
One instrument I like to suggest that fits well is managing risk with options to maximize cash flow payout profiles. Using collars, or selling puts and buying calls to manage your feedstock cost, is often a nice way to keep the tail-risk or, in maximizing cash flow, et al, metrics with these simple instruments.
Again, though, doing this means you can demonstrate in your disciplined process that you are maximizing the payout profiles by using the collars vs. a swap vs. a fixed physical price risk management.
As I write this, this may not be as attractive as two years ago, or is it? Look at the forward curves – some serious contango out forward, or just flat? On any given day, I can see opportunity to buy some forward year collars as basic supply/demand fundamentals, et al metrics, suggest these curves will roll-down. Maybe you can, instead of buying two-year natural gas or oil strips, buy collars too? There is cash flow to maximize in today’s world!
As you begin using these strategies, I would print the optimization results and attach them to the trade-ticket(s) to create a historical record to measure and for support for future needs. I.e. no perceptions here, just the fact please, sir.
Otherwise, revisionist history, human nature, politics, and those reactionary people who have something to prove in their new role, below and/or above you can cause problems down the road. Let’s not have those problems, those perceptions and let’s have the tools and the documentation to assert our capability when necessary.
Optimal Trades That Don’t Have Good Cash-Flow!
Above all else, many firms have this as their first goal, not profits. Debt covenants, meeting payroll, and just flat out “getting by” is important.
This may seem like an innocuous topic, but I have seen where normal trading activities to one-off trading are not optimal. Sometimes it is not noticed, but in situations where cash flow is a constant source of challenge, be careful not to make trades that are not clearly understood in relation to it.
Often, traders think it is a back-office accounting problem, not their problem. That old school, throw it over the wall mentality is backfiring, and no longer acceptable.
I have seen arbitrage opportunities, my main point here, where someone makes a trade, and this arbitrage opportunity requires cash today to receive cash back in the following fiscal year. It may make money, but it may also interfere with other issues at the corporate level.
The point is that if your company is only getting, say, for example 1%, for the cash in the bank and you see an opportunity to arbitrage an energy trading play for 5%, don’t assume the company believes it is good. In doing that play, ensure all calculations are blessed by the accounting department, not by your trading smarts. We all wear an economic hat, but at times economics is not always the best short-term strategy due to these debt covenants, and other legal items that do take precedent at times.
Again, perceptions and human nature are greater than reality. It is great thinking to be looking out for these opportunities, and another when a major financial institution hands it to you.
There is a reason an arbitrage opportunity with material margins exists in today’s lightning-fast world. Questions to ponder are whether this trade is clear, and whether crossing fiscal years presents issues with debt covenants to basic misunderstandings.
I realize I have not provided detail on this example, and it is to protect the innocent. The point is, if you do not have clear documentation on day one, and nine months’ fly-by before you collect the cash, watch the perceptions, not the facts, start flying around. I have seen this often, and I see the frustration of people walking hallways saying, “I told them nine months ago.” Show me the documentation supporting the clarity.
No discernable communications, and guess whose fault it is?! For certainty, just give me a ring and I will have my staff review the trade, documentation and internal culture to ensure the trade(s) fit into the short and long-term objectives.
Leveraging Financial vs. Physical Operationally – Curve Management
If I suggested that you should also hedge with financial instruments, even in the same exact manner, would you consider it more of a hassle, or can you see where it is creating optionality, flexibility?
If you have not just a local understanding of spot to forward markets, you can trade-around, or leverage the spot to forward markets when you have financial hedges in combination with fixed firm physical hedges. There are pennies, and nickels and dimes, and quarters, and even dollars if this is understood in relation to the cost of carry – i.e. storage, supply/demand issues in the prompt, spot month vs. the forward months.
Rolling hedges and/or physical storage, allow one to take advantage of correlation changes in the spot that will allow you to capture these periods of opportunity, and then roll hedges forward, roll physical forward, or vice versa
If managing the “curve” or managing the basic net present value of money, which is basically what I am articulating is a new concept, I would suggest we visit to discuss how this is used against many hedgers to pick up these pennies daily. These pennies turn into Porsches, Teslas, and some high living standards for those who do understand and leverage it against basic hedging programs.
We again could write and discuss untold examples and opportunities in this arena where hedging and service providers, (of feedstocks to real-time trading) is not optimal. The point here is to generate additional thoughts, getting you thinking differently and looking at market opportunity and market volatility as your friend.
A friend even in a hedging program, is trying to keep that Porsche money within your company, not giving it to that the super nice person who is trying to get you to continue the vanilla physical hedging program.
Therefore, let’s continue with specific tactics. This depiction will be somewhat like those textbook-like hedging and trading books, but not exhaustive and again used to help get one thinking differently about hedging. Why?
No hedging program will be similar in any company, regardless of the market and location. All companies have varying budget constraints, goals, and strategies in meeting their objectives.
Storage
This is simply nothing more than determining whether your physical fixed price purchases or storing feedstocks are the most optimal strategy at any given time that you are executing forward hedges.
Said another way, the price of your forward fixed physical purchases is based on this economic factor of cost to carry. The flexibility storage provides is like a free embedded option, especially in times of operational and/or shorter term supply/demand issues. We certainly have plenty of supply opportunities today to capture lower short term pricing.
For example, as we exit the winter of 2015/16, there is so much natural gas in the ground that, if I owned storage, I would be looking to exit that quickly, and run short in the nearby, and roll my hedges forward as the shoulder months which will certainly be offering some nice short-term, and possibly, long-term opportunities. If this sounds like Greek to you, please call to discuss as this is not removing short-term hedges.
I will provide you an example. I have seen first-hand where companies are buying or selling feedstocks just to pick off the vanilla hedgers by offering them a deal, a discount from the spot. In reality, they were sharing the “roll” with the customer.
The customer thought: What a good guy. Behind the scenes they were high-fiving and emailing each other about how they just took an easy $.10/MMBTU or $.50/BBL in oil from the customer by playing economics, basis and/or timing economics.
Even when I traded, my portfolio goals were not short-term trading gains, but to move the average duration of the portfolio, in years, out as far as possible as I was trading economic margins based on current and expected supply/demand fundamentals of the markets.
Therefore, you would expect I would not own inventory of anything. Quite the contrary, I held several different products in storage to manage correlation risk, from oil to gas to natural gas liquids, including physical chemicals. At one point, we even held hundreds of railcars of plastics. When the economics of the forward curve started playing out, we would buy or sell even more. We were picking dollar bills everywhere. It was just basic net present value economics.
Pre-Pays
There are two kinds of pre-pays. The first, which I will spend no time on, is for credit reasons. Sure, there are companies who must pre-pay due to credit issues. Enough said.
The second are those who are pre-paying, when they do not need to, to achieve a perceived discount. I will use the word “perception” here. If anyone is offering a pre-pay, they have an objective too, especially when it involves years, and even decades, forward. Enron started that program, and I saw it in 1994. I have seen many of these throughout the years and they rarely make economic sense, regardless of the math.
An originator is not selling physical fixed priced commodity to you. They are using commodities as the lever, but the play is to lock in an arbitrage from the commodity desk to the interest rate desk to bank a lot of cash. That reason is economics from either the energy curve or through an M&A or debt deal.
Therefore, there is much more to the story, and if you play this card well, you can uncover and discern whether it makes sense, and ask for much more in the negotiations.
Let me ask you this way. Why would you engage into a contract that locks-in a 15-year feedstock deal, and pre-pay that deal, on an index or fixed price with just one counterparty? For clarity, for just locking in supply, not building a plant or a pipeline, just for supply? Concentration risk alone may not be worth it for a trading deal.
Another way to look at it is that if you have a crystal ball out forward for 15 years, just for contracting trades, again not building plants or pipelines to meet your needs, why would you engage in nothing more than financial instruments, or at least a combo of physical and financial?
I don’t have the answer for you. It is simply a question to ponder, and to consider into your situation.
Add the concentration risk I first articulated, and it is much riskier to enter into physical deals that put you at risk to replacing that physical deal when their own credit issues surface, as we have learned in the last 10 years.
My point is that you cannot trust long-term physical trading deals that go beyond five years. Building plants and pipelines and transmission lines are another story. Trading long-term does not necessarily correlate, especially physically, to simply lock-in supply.
For those who are not convinced, is there a power company today that could say 5 or 10 years ago, and for some in the last year or two depending on what party of the country you live in, that negative pricing is taking many by surprise? It is.
Unwinding financial deals is one thing, but unwinding physical long-term deals for over five year periods is not going to be liquid. If you already have the tools to do these optimization calculations, you probably have some of that story painted and can articulate it well.
For those, who are smaller and trying to create more certainty, I understand. Just know there are companies seeking less than optimal, and many times, deals that are monetizing their current state without regard for your future state.