When hedging is gambling

And what the real cost of hedging has been

The Canadian Oil Mafia (#COM) on Twitter has a great gang of smart investors exchanging ideas daily. Not surprisingly, it is not an echo chamber and there are well-reasoned and strong views on both sides of the debate on “hedging” by oil companies. Often those companies, set out to protect against a calamitous fall in commodity prices by buying puts and pay for those puts by writing above the market calls - a scheme often called “costless collars”. Example, the oil price is $75, so buy a put at $60 and write a call at $90 for the same premium and you will never get less than $60 for the oil you produce and never get more than $90 should prices rise. If your all-in costs are $30, it seems like a win-win game and many oil executives buy into this strategy.

But who says the oil price is going to remain below $90 (that is in fact the bet)? How can we assess that probability? Is the sacrifice of gains above $90 worth the protection you get if prices fall? These are fundamental questions and by no means easy ones.

Individual investors owning oil stocks actually face precisely the same dilemma. If you own 2,000 shares of Whitecap ($WCP.TO) you purchased at $4.05 a share and the price has risen to $6.00 a share, should you let it ride or write a covered call at $7.50 for a $0.50 premium for 6 months and use the proceeds to buy a “put” at $5.50 for the same premium and “hedge” your bet? I used this example since I could dig up a June 2019 transaction record for one purchase of Whitecap I made, and chose this one instead of my subsequent purchase at $1.01 per WCP.TO share since that would make the case too obviously.

I didn’t write any calls but had I written a call on 2,000 Whitecap the stock would have been called away at $7.50 and I would keep the $0.50 premium so ignoring commissions I would have realized $16,000 on my $8,100 investment, a nice double. Sound like a deal?

Not for me. With a looming global energy shortage and no evidence of a supply response, I (like many experts in the industry) saw the risk of higher prices as more likely than lower prices. I kept my Whitecap which today trades at $11.25 a share and if I sold today (which I most definitely will not) I realize $22,500 instead of $16,000, so the actual “cost” of writing that call would have been AT LEAST $6,500. I say and emphasize “at least” since there is still no sign of a supply response and my valuation of Whitecap (using modern valuation techniques) puts an underlying value of the stock around CAD$23 a share using an average oil price of CAD$100 for Whitecap’s product mix rather than the US$117 WTI price today. If I am close, the opporunity “cost” of writing a call at $7.50 when the stock was prices at $6.00 would have been about $30,000. Leaving as much as $30,000 on the table to protect a gain of $8,000 just does not make sense to me by any logic.

There is a lot of evidence that commodity prices are not chaotic but follow a lognormal probability distribution. Black-Scholes option valuation assumes such a distribution in pricing options, and the Delta metric is a proxy for the risk of a call at any given price being exercised before its expiry. The actual risk is a first derivative of price with respect to strike given time and volatility but Delta is close.

For readers who doubt I purchased any WCP.TO at $1.01 a share, here is the confirmation slip.

One reason my energy portfolio outperforms is my formal approach to quantifying risk and avoidance of management teams who seem to ignore formal mathematics in favour of conventional wisdom and “gut feel”. That has yielded decent returns. Here is the performance report from my brokerage account.

I don’t post this to brag since that advances nothing, but to inform readers that the energy market remains a positive space and if you fear losses by all mean buy puts or otherwise protect your gains (e.g. by simply selling), but writing calls above the market will do no more for you than it did for $ARX.TO whose hedge book cost them over CAD$800 million in Q1 and I estimate will cost them over CAD$3 billion this year.