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Oil disputes: the ins and outs of hedging
Oil disputes:
the ins and outs of hedging
[WHILE THERE IS an oil industry there will be licence agreements, production sharing contracts, lifting agreements, transportation pipeline agreements, tanker charterparties and sales contracts. There will be financing deals and price risk management contracts, both on regulated exchanges and in the over-thecounter market.
Sadly, where there are contracts, disputes arise. When there are hedges involved and experts are wheeled out to give an opinion on oil contract disputes, certain questions recur in calculating damages. For example: • Where there is an ‘available market’ and damages are calculated • based on the difference between the contract price and the market • price, which components of the oil price can be hedged? • If the party doing the hedging is an oil producer, how much hedging • should it undertake to protect the revenue stream that it receives • after the terms of its production sharing contract are applied and • royalty, cost recovery, profit sharing and tax are taken into account? • In particular, how much hedging should a producer undertake if its • hedges are taxed at a different rate from its oil production?
As anyone who trades in oil companies or oil assets could testify, the revenue stream from an oil field typically has been comparatively under-analysed compared with the extensive examination given to costs. After being asked the same questions on revenue and hedging on many occasions, Consilience has built the Revenue Analysis, Apportionment and Hedging (RAAH) software application. It gives quick and easy answers to the many ‘what if?’ questions that are asked by oil asset dealers, oil producers and oil cargo traders in their daily business and which also get asked during a dispute.
Based on the user’s own input assumptions, relevant to the asset in question, RAAH allows the user to analyse up to 20 fields over a 20-year period. It splits the oil price into what is hedgeable (the benchmark price) and what is not (the differential to the benchmark accounting for differences in quality, timing etc). It breaks down the total revenue stream into the portion that is paid as royalty in cash or in kind, government profit share and tax, and the portion that is retained by the company as cost recovery and the revenue from the sale of retained barrels.
RAAH constructs a hedge scaling factor that tells the producer how much hedging it needs to undertake to protect its retained revenue stream after royalty, profit share and tax. It considers any differences in the tax rate and other deductions that apply to the gross revenue stream from the physical oil and the tax rate that applies to hedge gains or losses. That is particularly relevant to oil field financing deals, where the lender may insist that the oil price base case assumption in the economic model for the asset is hedged. Unless hedges are scaled the producer can find itself over-hedged.
Using RAAH in the right circumstances cuts the amount of analytical time needed by the expert witness, thereby cutting costs.
Oil is not a dirty word
The wise words ‘The Stone Age didn’t end because we ran out of stone’ have been attributed to several people, but are probably most closely associated with Sheikh Yamani, the one-time Saudi oil minister of the 1970s and 1980s. The concern at that time was about ‘peak oil’: in other words, as the international economy grew and developed, it was feared that we would run out of the oil on which we were so reliant.
The good Sheikh was reassuring us that before we exhausted our fossil fuel supplies, human ingenuity would have found alternative energy sources. Also, our ability to retrieve more inaccessible supplies of oil economically would have evolved and improved before the known reserves ran out.
It is time to update Sheikh Yamani’s maxim: ‘The Stone Age didn’t end’ – full stop. We still use stone extensively – just ask any architect or builder. But we use it more sparingly and wisely. So will it be with oil and other fossil fuels. The oil industry is here to stay. q • Liz Bossley established the Consilience Energy Advisory Group Ltd in 1999. Her career spans more than 45 years in the international crude oil, refined product and freight markets, comprising trading, risk management and hedging, marketing and extensive experience of contract negotiations. She is a certified expert witness for oil and freight trading and logistics and has acted in more than 50 disputes.
Learn more about Liz Bossley at ceag.org/founding-partners and about RAAH at ceag.org/oil-field-hedging-software.
