This section is separated to focus the reader on macro-level hedging vs. micro-level feedstock or product hedging. There are many approaches, and I will share how a few of these at first glance show no compelling reasons to use a hedge. But, after showing a few examples and some additional thought, that macro-level benchmarking to structural hedges that can take the tail-risk out your natural position.

 

Benchmark Hedging – Implied Hedging

There are many traders and companies that want to ensure they can manage their portfolio in a liquid manner. For any market, there are traders who want, can or are instructed to trade their natural position back to a benchmark price setting mechanism which they do to ensure very controlled, maximum risk/reward programs.

A couple of examples are worthy.

First, you may buy electricity for California from another state, but your benchmark may be SP15 for SoCal. That power does not originate in California. It is produced in many other states, including wheeling from Canada. Or, Canada into Michigan, MISO. It could be the plant is in South Texas, but the power needs to be delivered to North Texas.

Do you want to maximize your risk of where the power is produced?

The same for natural gas. Many companies trade off their SoCal or Chicago City Gate or Katy back to Henry Hub to have a benchmark position.

That leaves a portfolio though with basis and even emission risk to maximize and to trade off for cost savings/avoidance to making money.

Therefore, on any given day, if there is a natural gas natural short position for power in SP15, there are companies that will create basis positions, not real, but implied in their risk profile and measure both the local SoCal and Henry Hub Nymex risk profile to decide, based on risk/reward, or supply/demand, and cover or leave open that basis risk.

The same in power, but the basis may be an emissions and/or renewable credit that can be avoided, traded and/or monetized, if you will.

In oil, it may be as simple as measuring all risk back to Cushing, or using multiple world-wide benchmarks.

In natural gas, Henry Hub, for all natural risk that can be traded away via basis swaps.

This is probably resonating with many who do this well. There are those who are “thumbing it” based on how they feel that day vs. truly understanding via the proper valuation/risk measurement tools to maximize their position, their cash flow and budgets.

 

Structural Hedging

There are what many call “structural competitive positions” in many markets that some have also suggested were comparative advantages.

For example, North American based chemical plants had a comparative advantage of natural gas feedstock vs. the rest of the world using Naphtha as their benchmark.

WTI vs. Brent crude oil is another that flopped from one over the other – i.e. Brent crude oil is more expensive than WTI.  Supply/demand is the reason for this one, which is simple vs. the alternative feedstock example seen in chemicals.

That is, chemicals, for example, had a comparative advantage until that one thing happened starting in the beginning of the 21^st century – change!

Today, we are seeing more and more of this change, and at an increasing rate. Therefore, understanding these opportunities may not exactly fit your profile, but they should be a catalyst to move your thinking for your business to not consider, but to plan for.

You will also discover that many have been using these macro-level hedges at the corporate level, regardless of the level of hedging done at the micro-level, or division/department trading group levels.

Why are they separate and/or different?

Incentives and appropriate control and oversight, including to not confusing the department level and keeping them focused on their risk and rolling their positions to the corporate level to then macro-hedge across the entire entity.  This may seem curious, at this point, or not clear, but read on and it will.  If not, call me to discuss.

Many companies, (most), who have faced many of the examples below made a decision, a decision to do nothing and it has hurt their reputation from shareholders to customers, and has caused several to go out of business.

 

WTI vs. NG

Over long periods of time the parallel between WTI and NG is poorly correlated. Without the dissertation, oil is generally more global; whereas, natural gas is more regional.

I have seen several attempt to trade this spread consistently, but since one doesn’t feed the other into a margin, there are many factors as to why, and when they do correlate, it makes perfect sense, but most often each is mutually exclusive.

These two as a trading strategy though have been shut down, one after another for most who attempted it. Are there are any structural macro-hedging opportunities, though, that would peak your interest?

 

Heating Oil Vs. NG

Again, we can find short-term correlations in the winter, but in general, these are only marginal, save you can switch or optimize these between the plants you own. If you do, you already know the structural possibility.

NGLs to Chemicals?

To many, this is an economic margin, but to play it, and consistently profit from trading it, due to liquidity, it is spurious to suggest you can do this beyond short periods of time.

NG vs. Coal?

This again is a cost switching play for those who optimize power plants. As coal has become more liquid in trading in the last decade, it is a newer trading market. If you owned just a coal plant what would you do to protect that plant?

These are just a few areas I will introduce that appear to be switching cost-related to specific plants, or for those who are just price-takers. Those who we say “just own” natural gas feedstock chemical plants, or we “just own” coal plants, say those put us in a situation where there is not much we can do. Hmmm, interesting.

I suggest we can challenge their thinking sooner than later. For some, it may be too late, though.

For those who do have time, and willingness to explore alternatives, there are clearly structural, macro-level hedging opportunities within these spreads.

In other words, switching economics not at the micro-level in trading, or even for many companies to hedge directly in their feedstock to product margins, but risk their plants becomes less cost effective, even obsolete, due to switching, or structural market changes are available.

For example, for decades, until the Saudis about 10 years ago, the United States had been purely a net exporter of plastics to the rest of the world.

Why?

Natural gas, on an input basis to WTI, and/or better yet to Naphtha, had what was thought to be not just a competitive but comparative advantage that could never be broken, even in short periods of time.

That all changed in the early 2000’s, when natural gas spiked to $4, to $5 to $6/MMBTU. I.e. the switching ratio at 5.8 of NG to Oil, and the cost advantage on the USGC spun around, unlike before, and the U.S. not only stopped exporting, but a few Asian firms started literally dumping plastics, et al chemicals, into the U.S. and completely disrupted chemical markets.

Therefore, the natural gas based (via the extraction of Ethane and Propane) chemical plant’s products were less attractive in costs and drove many to shut production. Many chemical plants got mothballed.

Though we have not built a refinery in the U.S. since the 1970’s save incremental capacity increases to existing plants, if you have not worked in chemicals, you would be surprised to discover how many chemical plants have not just shut down, but also many larger, for costs reasons, plants have been built in the United States within the last few decades. A very cyclical business beyond what one may wish for.

Fast forward to 2008, it just got worse for a while for US chemical producers again as Nymex Natural Gas was printing ~$13/MMBTU. Suddenly, oil recovered quickly back to $100, natural gas dropped, due to industrial demand destruction, and the U.S. natural gas chemical business skyrocketed like never before with a great cost advantage until the recent years when oil fell back into reality precipitously, again.

Therefore, to suggest that one can trade or hedge their chemical plants in the U.S., due to liquidity, and poor correlations did not provide itself opportunity to U.S. chemical companies?

Or, did it?

You can see I am leaning toward the possibility, and will depict the fact it was there, we were cringing when it did present itself over 10 years ago, not for ourselves, but for the fact we couldn’t convince U.S., North American chemical manufacturers to see this and do something about it – i.e. let us manage your risk for you. They didn’t.

What specifically sets the marginal cost for plastics world-wide?

Natural gas or Naphtha?

Since most chemicals produced come from Naphtha, the price for chemicals marginal revenue is generally a cash cost of Naphtha + fixed costs + variable costs. For U.S. based it is Ethane for straight away Polyethylene, the predominant chemical produced, so Ethane converted to Ethylene and you have a cash cost that basically implies back to natural gas.

We debated this wildly during the early 2000’s, as to what was and will be the marginal cost-setting mechanism. It is clear it will go to natural gas based marginal cost setting one way or the other, one decade or two down the road.

I share chemicals immensely as we built autoregressive simulations where we were presented with the issue of what was the tail risk for chemicals. The markets were changing, but not as fast as power markets are changing today with negative pricing – another story.

At that time, oil was only ~$40/bbl. I argued that chemical intermediaries, such as Ethylene, could go to $.50/lb. and that we should not constrain the models, nor completely rely on historical data – i.e. yes, at that time it meant the tail risk would have to take oil to $100+.

In 2006, a few years later, in my cover story article on risk management, I stated a $100 oil risk then, and 1% interest rates as a risk, when oil was $50/bbl, which provides consistency and validation in my thoughts and approach for years in the trading and risk management arena.

However, if NG rose quickly, or oil dropped quickly, we have seen major, structural shifts in the importing and exporting of chemicals alone in the US.

This is one reason why the Saudis built chemical plants. They were macro hedges to the landscape of oil prices. Many would say it was simply because they flared natural gas and just needed a reason to leverage it.

That is part of the story. Most of it was portfolio diversification, hedging that oil may not exist forever, and through plant building, which is risk management, which is hedging, they balanced their concentrated oil portfolio risk to cleaner burning fuels to manufacture chemicals.

Therefore, the point is that structure changes to markets can be seen, and managed, but not with every day normal course of margin-management hedges for your natural position.

The point is that as U.S. chemical manufactures margins increase, there is either pressure to develop more plants with the same feedstock, and/or other market forces will correct themselves. Said another way, commodities generally are mean reverting, in margins certainly, and somewhat to price to long-run discernable averages.

Prices can dislocate from one commodity to the next, as we have seen with oil for many years. Agriculture has seen this, too, in the recent decade, and then it has also simmered in recent years.

Economics can only allow a price of goods to go so far before demand destruction appears.  I.e. supply is chasing and producing faster than consumption with human nature chasing it to the extent the markets crash.  The pendulum swings, some washout, and some recover and maintain. The only certainty is that we know agriculture will take off again.  Energy will follow.

 

How to Macro-Hedge Structural Change

As we have learned, there is no perfect hedge, as a perfect hedge does not exist in capitalism. However, as a U.S. NG based chemical producer, and especially as margins grow, I would begin buying deep out-of-the-money oil options to cover the macro-economic risks faced.

Round two, by the time this was published this second big wave of U.S. based natural gas advantaged feedstocks has eroded. But, the concept can be applied across other markets, so we continue.

Or, start selling WTI vs. NG spreads – not a great fan of this, but one can see the economic switching, at a macro-level, at a 5.8 ratio of oil to NG that if NG is $5 and oil is $100/bbl., that the NG equivalent is approximately $29/bbl. However, in looking at this way, it was fine when Ethane margins were sitting at a fixed cash-cost of $.02/gallon. A trading play, a synthetic asset play which we will discuss.

If you also follow the midstream chain, you can basically discern how chemical markets are performing. Big Hint.

Other thoughts for chemical companies is to play Ethane to NG or Ethane to Naphtha, or even WTI spreads. That sounds crazy to some, I am certain. But, to a few, this makes perfect sense.

Let me further articulate this macro-hedging through another example, and then come back to Ethane, et al, especially to build hedges, and even leverage hedging into optimal asset modeling via synthetic hedging or synthetic plant building.

 

NG vs. Coal as a Hedge?

If you live in Texas, you know natural gas is the marginal cost of production for utilities. But, if you also hold coal fired plants, you know there is risk that if natural gas falls below the switching cost, the marginal cost for coal, your coal plants will economically, not just environmentally, shut down just as many chemical plants have shut down.

However, in the early 2000’s, I was just beginning to get into power and was not that focused on power’s marginal cost as it was a regulated market, so who cared. As deregulation was coming, there was a company that in the early 2000’s saw what the chemical markets could see coming, and did something about it. They hedged NG vs. their coal plants. Their structural hedge, at the corporate level was in place vs. the marginal cost for their products could become uncompetitive.

Same issue as chemicals with respect to natural gas, but it was not due to Naphtha, or an oil related product. It was due to coal. Same problem as chemical’s, and as someone once told me, “It all taste like chicken.” You will begin to digest that as reality, the more and more you move through these markets.

Therefore, this company started shorting natural gas futures for years and years forward, and did this as a corporate hedging strategy, not at the trading or any division level. What kind of company did this? A power utility company shorted natural gas futures to the extent their power assets were long coal-based feedstock.

They couldn’t switch a coal plant to natural gas, so they started doing macro-level hedging, even though the correlations were poor as we have discerned, but did the macro-level hedging in a way that provided insurance against their assets becoming worthless.

Did they give up the upside of coal cash flow and profits vs. natural gas when natural gas prices increased? Yes, they did. They had debt covenants, budgets, and margins to protect. That was their risk/reward profile they wanted to protect.

Their debt covenants had cash flow, et al, metrics and one of the biggest risks was that natural gas dropped below coal on an equal BTU basis. This was thinking macro and connecting-the-dots of their risk profile to their budget, cash flow and debt, and legal obligations.

When natural gas prices increased, and though they were paying away on those for a while, they didn’t flinch as the cash flow for coal-based assets, not perfectly correlated, did provide relief for high natural gas prices.

Over the long-run, the strategy worked very well. Notice, I didn’t say for six months after Katrina they reacted, or did they react to the financial crisis. They stayed the economic course.

Today, power markets are changing so rapidly that we are seeing negative prices. There are untold opportunities to manage structural change at both the macro and micro-level.