WHAT EVERY CORPORATE COUNSEL NEEDS TO KNOW ABOUT HEDGING TRANSACTIONS

Transcription

1 WHAT EVERY CORPORATE COUNSEL NEEDS TO KNOW ABOUT HEDGING TRANSACTIONS ACC HOUSTON BACK TO SCHOOL SYMPOSIUM August 30, 2018 C. Randy King, Partner Porter Hedges LLP 1000 Main, 36 th Floor Houston, TX (713)

2 OUTLINE Introduction What is Hedging? Example of Hedging by Swap Terms of Art Mix and Match More Terms of Art Mark-to-Market What is Speculation? Corporate Hedging Policies Platforms and Regulation Terminology and Tidbits Credit Support for Hedging How are Derivatives and Forward Contracts Treated in Bankruptcy? Setoff/Early Termination 2

3 INTRODUCTION Randy King is Co-Chair of the Energy Section of Porter Hedges. His practice focuses on a wide range of energyrelated projects located onshore, offshore, upstream, midstream and internationally, including: C. Randall King Partner rking@porterhedges.com acquisitions, divestitures, construction and financing of pipelines, gathering systems and storage facilities for natural gas, crude oil, condensate, natural gas liquids and LNG acquisitions and divestitures of producing and non-producing oil and gas properties oil and gas joint ventures and exploration and development programs exploration and development project agreements including joint operating agreements, COPAS accounting procedures, exploration and development agreements and joint operating agreements natural gas purchase, sales and marketing agreements and NAESB agreements natural gas processing and treating agreements, oil and gas transportation agreements, natural gas storage agreements, natural gas supply agreements operating and maintenance agreements for mid-stream facilities production handling agreements master service agreements and IADC drilling contracts hedging, derivative, swap and ISDA agreements Mr. King is listed in Chambers USA among the leading lawyers in the area of Oil & Gas Transactions. He has also been selected for inclusion in Best Lawyers in America in Oil & Gas Law, the Houston Business Journal's "Who's Who in Energy" list, and recognized by ALM as a "2013 Top Rated Lawyer in Energy/Environmental." Prior to becoming a lawyer, Mr. King spent 13 years practicing as an independent petroleum landman. His experience included negotiating oil and gas leases, title examination, structuring oil and gas property acquisitions and exploration transactions. Mr. King has been a Certified Professional Landman since He received his J.D. with honors from South Texas College of Law and his B.S. with honors from Stephen F. Austin State University. Mr. King is licensed to practice in Texas. 3

4 WHAT IS HEDGING? What is Hedging? An investment position intended to offset potential losses that may be incurred by a companion investment, product or commodity that a company makes market in, produces or consumes. For example: An electric power generator that buys natural gas in the open market at the index price and invests in a natural gas swap transaction to secure a fixed price for the natural gas it will buy in the open market for the next three years. A natural gas producer that regularly sells natural gas in the open market at the index price and invests in a natural gas swap transaction to secure a fixed price for natural gas production that it expects to sell over the next three years. The commodity trader who is the counterparty to both the power generation company and the natural gas producer in the swap transactions contemplated above. A farmer that sells corn futures to secure a fixed price for his corn crop. A business with a floating interest rate loan that does an interest rate swap to secure a fixed interest rate. 4

5 EXAMPLE OF HEDGING BY SWAP What is Swap? A derivative contract where parties hypothetically swap cash flows derivative to a fixed price and a floating bench or index price for a chosen commodity, an interest rate, etc. Gas Marketing Company Natural gas at floating market index price settling monthly Electric Power Generation Company Swap Contract at fixed monthly price offered by Counterparty Swap Counterparty How a swap works: Swap provides that EPGC is the fixed price payor and SC is the floating price payor If floating index price for any month is lower than the fixed price, then EPGC pays SC the delta. o Vice Versa o So, as net, EPGC only pays the fixed price Floating price is set at beginning of Transaction for each calendar month. Settlement is monthly one party pays the other after close of each month. Example: Month Fixed Price Floating Price EPC pays Jan Feb March Swap counterparty pays 5

6 TERMS OF ART What are futures? Financial contracts obligating the buyer to purchase an asset or the Seller to sell an asset, such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures can be used to hedge a loss or to speculate. Example: Farmer that sells corn futures to secure a fixed price for his corn crop. Futures can be settled by (1) closeout (taking an opposite position before expiring), (2) physical delivery or (3) or cash settlement. When speculating with futures you are long or short. 6

7 TERMS OF ART What are options? Options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price at any time before a certain date. Options can be used to hedge losses or to speculate. Example: Stock market investor that sells or buys a put option on a stock that he considers a shaky investment to hold. These are call and put options. Options are purchased and sold for up-front consideration. 7

8 TERMS OF ART What are physicals and derivatives? Physicals: An actual commodity or product that is sold as a physical item, for example natural gas, oil, grain, pork bellies, cattle, etc. Derivatives: A derivative is a financial transaction whose value is derived from an underlying physical commodity or product. For example, swaps, options and forwards for stock, currency, oil, natural gas, grain, pork bellies, cattle, etc. 8

9 MIX AND MATCH Can you hedge physicals with derivatives? And, vice versa? Answer: Yes For example see example of where electric power generator hedges its monthly physical natural gas purchases with a swap transaction. Can you hedge derivatives with derivatives and physicals with physicals? Answer: Yes Think of some examples? 9

10 MORE TERMS OF ART What is basis differential and how do you solve for it to create a perfect hedge? Definition #1: Basis Differential is the difference between the spot price of a commodity to be hedged and the futures price of the contract used. You don t usually try to solve for it. Example: The diminimus difference between the Henry Hub spot price of natural gas and the corresponding futures price for natural gas when finally settled. Definition #2: Basis Differential is the difference in price for the same commodity at different market hub locations on the same day. Example: The difference between the spot price of natural gas at Henry Hub vs. Houston Ship Channel. This is usually a static number but sometimes can vary greatly. You solve for it by a basis differential swap. 10

11 MARK-TO-MARKET What does mark-to-market mean? In the hedging credit context, it means to calculate the current positive or negative value of all of the remaining months under a derivative transaction as compared to the current market value of each such future month to determine the net exposure of one party to the other over the remaining term of the transaction. In the context of one s whole book, it means to calculate whether your book of transactions is in or out of the money on a net basis. If your book exposure is not zero, you are speculating. 11

12 THE BIG TAKE AWAY: SPECULATION IS RISKY What is Speculation? That portion of any investment position in a product that a company makes market in, produces or consumes, not hedged. Examples: Buying an option to sell shares of stock you don t own. Entering into a swap to secure a fixed price for natural gas you won t be able to produce. Not entering into a swap for natural gas you are able to produce. Caveat for Speculation: Speculation can cost millions/billions! Caveat for Hedging: Hedging takes away the upside. 12

13 CORPORATE HEDGING POLICIES Corporate Hedging Policies: Equity Securities Many companies have rules against executives hedging the company s equity securities. Commodity, Currency or Interest Rate Risk - Many companies have written policies on whether and under what circumstances the company enters into hedging transactions and forbidding or restricting speculation. 13

14 PLATFORMS AND REGULATION How Derivative Products are Traded Exchange Traded: Standardized derivative contracts that trade on a regulated exchange, for example: Futures Options Over-the-Counter Traded: Customized derivative contracts that are privately negotiated directly between two parties, without going through an exchange, for example: Swaps Collars Floors 14

15 PLATFORMS AND REGULATION How are physical commodities traded? Private Marketing Agreements: For example, natural gas producer s agreement to sell its natural gas produced from the Eagle Ford formation in Texas to a marketing company like J. Aron & Co. or Shell Trading. Future Exchanges: For example, a futures contract on NYMEX for natural gas when it is settled by physical delivery of gas, instead of being settled for cash. 15

16 PLATFORMS AND REGULATION Regulation of Derivatives: Commodity Exchange Act (1936): Provides for federal regulation of all commodities and futures trading activities and requires all commodities, futures and options to be traded on organized exchanges. Commodities Futures Trading Commission Act (CFTC) (1974): Oversees designated contracts market (DCMs) or exchanges, swap execution facilities (SEFs), derivatives clearing organizations and other intermediaries. 16

17 PLATFORMS AND REGULATION Regulation of Derivatives: Dodd-Frank Wall Street Reform and Consumer Protection Act (2010): Expanded CFTC s authority into the swaps markets to curb manipulative schemes. Every party to a swap is required to register for a legal entity identifier for recording and recordkeeping purposes. Qualifications for Swap Dealers and Major Swap Participants. Verification that counterparty meets standards for an Eligible Contract Participant. Eligible Contract Participant is an entity (corporation, partnership, proprietorship, organization or trust) that (1) has total assets of $10 million or (2) has a net worth of $1 million and enters into a contract to protect the value of its assets or manage the risk of its assets. See 7 U.S.C. 1a(18). Established clearing requirements for certain types of swaps (e.g., interest rate swaps and credit default swaps). 17

18 PLATFORMS AND REGULATION Exchange Name Chicago Board of Trade (CBOT) Chicago Mercantile Exchange (CME) Intercontinental Exchange* (ICE) Kansas City Board of Trade (KCBT) Minneapolis Grain Exchange (MGE) New York Board of Trade (NYBOT) New York Mercantile Exchange (NYMEX) Commodities Traded Corn, ethanol, gold, oats, rice, silver, soybeans, wheat Butter, milk, feeder cattle, frozen pork bellies, lean hogs, live cattle, lumber Crude oil, electricity, natural gas What, natural gas Corn, soybeans, wheat Cocoa, coffee, cotton, ethanol, frozen concentrated orange juice, sugar Aluminum, copper, crude oil, electricity, gasoline, gold, heating oil, natural gas, palladium, platinum, propane, silver *The Intercontinental Exchange is one of the only exchanges without a physical trading floor all orders are routed and matched electronically. It is, in fact, one of the only all-electronic exchanges. 18

19 TERMINOLOGY AND TIDBITS Forms for Hedges and Physical Trades: ISDA Master Swap Agreement The Schedule is where the action is! ISDA Credit Support Annex Paragraph 13 is where the action is! ISDA Novation Remember Contracts II in law school. Long Form Agreement really the short form for doing a single swap transaction. NAESB Common master form for physical natural gas purchases and sales. Transaction an individual trade under an ISDA Master Agreement. Confirmation written verification of some kind of terms of the trade between the parties to an ISDA Master. Conoco Terms General Terms and Conditions for U.S. Crude Oil Contracts published by CP and widely-used in the industry. 19

20 CREDIT SUPPORT FOR HEDGING Credit Support: - Credit is King OTC swap counterparties must provide credit support for their derivatives. Credit Support generally takes the form of: Parent Guarantees Letters of Credit Cash Collateral Intercreditor Agreement OTC swap counterparty shares collateral on a pari passu basis with other secured creditors. CSA: Threshold : The amount of free credit given to each of the parties to a swap after which any Exposure on a mark-to-market must be covered by the posting of credit support. ISDA: Threshold Amount : The size of default of any party or its Credit Support Provider under any of its Specified Indebtedness (usually any obligation in respect of borrowed money) that will cross-default the ISDA. Key Concept: Beware of springing requirements to post-credit support arising from hedge positions. 20

21 TREATMENT IN BANKRUPTCY Treatment in Bankruptcy: Forward Contracts and Derivatives have special treatment in bankruptcy. Exempted from automatic stay. Unlike other executory contracts, counterparties are permitted to terminate forward and derivative contracts with bankrupt debtors under the ipso facto clauses and seize collateral, without leave of court. Purpose of These Laws Some say it was to reduce system risk in financial markets that multiple market participants will file at the same time. 21

22 TREATMENT IN BANKRUPTCY In bankruptcy, setoff as among exact counterparties is permitted. In bankruptcy, setoff of debtor s obligations with those of counterparty s affiliates is generally not permitted, absent a qualifying Master Netting Agreement to the contrary. In bankruptcy, early termination of related contracts (e.g. gas gathering agreements related to forward contracts for natural gas) is not permitted in the absence of a Master Netting and Termination Agreement. 22

23 ABOUT THE FIRM Porter Hedges LLP 110+ lawyer, Houston-based full-service firm established in 1981 with an office in Oklahoma City. Business and trial lawyers experienced in a wide range of legal services across a broad spectrum of industries. Primary focus on oil and gas representing clients in both transactions and litigation across the full spectrum of the industry. 23