Capra Energy is proud to have assisted the State of Israel in the design of its transfer pricing policies for LNG exports.  The Ministry of Finance has publicly released the report, “Comparative International Review and Recommendations for Israel's Natural Gas Transfer Pricing Policy,” which is available here: Ministry of Finance website.

After reading E&Y's report, "Analysis of the competitiveness of BC's proposed fiscal framework for LNG projects" a few months ago, we were hoping that more details from their study would be forthcoming, since the analysis raised more questions for us than it answered.  But with no new information in the weeks since, we are still left without a clear understanding of the key assumptions underlying E&Y's results, which purport to show that BC's total government-take from its industry is comparable to or below the levels expected in Australia and 5 US States (Alaska, Georgia, Louisiana, Oregon and Texas).  Specifically, there are at least 3 key questions that E&Y's report does not address, the answers to which might fundamentally alter the competitiveness of BC's tax regime compared to those of other exporters:

1) Transfer Pricing - Tax rates are certainly a key driver of relative competitiveness, but transfer pricing is equally critical (see
British Columbia’s Next Challenge: Defining the Other Half of its LNG Fiscal Policy Framework), since it will determine how much of a project's total profits are allocated to the mid/downstream, and how much is retained by the upstream (where the total tax burden is typically higher).  Since BC has not prescribed a preferred method, E&Y should have specified the LNG feedgas transfer prices it used in its study or, at the minimum, its basis for determining these.  Unfortunately, this is missing from the report.  Also, we hope that the feedgas prices used for Australia accurately reflect its transfer pricing policy (i.e., RPM), and that appropriate prices were used for the US jurisdictions as well.  But it is difficult to conclude that transfer pricing was incorporated into E&Y's model correctly without further details.

2) Government-Take - E&Y presents two "Aggregate Taxes and Royalties" charts, one in real $2012 and the other in present value terms for 20 years of operation.  We are strong proponents of comparing tax regimes on a present value basis, rather than their aggregate undiscounted tax revenues.  This is especially the case when one or more of the tax regimes employs a sliding rate based on the degree of capital recovery.  For example, the present value of a cash flow stream of $100 million per year collected over the first ten years of a project is more than two and a half times as great (PV= $ 615 million, based on a 10% discount rate) as that of a project that collects the same nominal dollars, but in years 11 through 20 (PV=$237 million). 

So while we are pleased that E&Y included the present value results, they do not appear to be consistent with BC's tax structure.  Since it will take quite a few years before a project has recovered its capital investment, and entered the upper tier (7%) of BC's two-tiered LNG tax, we would expect BC's tax advantage over the other jurisdictions to be magnified on a present value basis.  But this does not appear to be the case.  All of the results across tax jurisdictions appeared to move proportionately across the two charts (i.e., undiscounted vs. present value).  These results therefore seem suspect, and more information will be needed to verify their accuracy.

By the way, Capra Energy will be comparing the present values of government-take, or "PVGT" as we call it, for different LNG tax regimes around the world in our own forthcoming study.  Please contact us if you are interested in securing a copy.

3) Rate of Return - A final issue that the E&Y fails to address is that of the appropriate rate of return.  This assumption factors into transfer pricing, since a rate of return would need to be used if E&Y applied any of the more common non-CUP transfer pricing methods (i.e., netback or cost-plus).  And where E&Y does mention a discount rate, in the context of its calculation of tax revenue present values, it merely states that a rate 8% was used without explaining the basis for this figur.  The reason this concerns us is that 8% appears to be at the very low end of what our expectations based on independent research and analysis, as well as international comparables.  A rate that is too low would result in overly discounted tax revenues in the calculation of PVGT (present value of government take), as well as unrealistic transfer prices.  

In our latest white paper, we explain why WTI's discount to Brent has persisted over the past several years, from a global macro perspective.  This is the first in our new series addressing the key fundamental forces driving today's international petroleum markets.

Click here for Why has the WTI - Brent Spread Remained Negative?

In the March 2014 issue of Commodities Now, Dr. Carlos Blanco of NQuantX, our alliance partner, and Tamir Druz of Capra Energy discuss the mechanics for pricing and hedging long-term LNG and natural gas transactions that are indexed to crude oil or petroleum product prices.  Using a sample contract, they present the step-by-step process for determining contract pricing and executing financial hedges for the underlying exposures (fuel oil, gasoil and foreign exchange risk).

Click here to read Hedging, Risk Management and Valuation of Long-Term Oil-Indexed Supply Contracts in the latest issue of Commodities Now.

Now that the Canadian province of British Columbia has released its plan for a two-tiered tax on liquefied natural gas (LNG) profits, it will soon need to address an equally important question: “Just how will those profits be determined?” This is more challenging than it might seem, since the prices paid for natural gas to feed LNG facilities around the world often do not reflect competitive market levels...

Please click here to download the rest of Capra Energy's most recent white paper, British Columbia's Next Challenge: Defining the Other Half of its LNG Fiscal Policy Framework by clicking below:

* Image shown is of the Sakhalin II LNG project; author is Shell.
Dr. Carlos Blanco of our partner, NQuantX (www.nquantx.com), and Capra Energy Group recently completed a case study laying out how an integrated framework can be used to address both commodity and foreign exchange risk within a single hedging program.  Using Michelin as our example, and relying only on publicly available data, we laid out an approach that any corporate with both commodity and FX exposure can use.  We also highlighted some very important (and often surprising) results, including the impact of longer hedging durations on the volatility of financial results, and how the timing and size of hedges can be optimized to improve risk-adjusted performance.

A version of this thought piece appeared as an article in the latest edition (December 2013) of Commodities Now (www.commodities-now.com).  

Please click here to access An Integrated Approach to Commodity and Foreign Exchange Hedging:  Michelin Case Study.

Berkeley, California

NQuantX (www.nquantx.com) and Capra Energy Group Ltd. (www.capraenergy.com) are pleased to announce the formation of a Strategic Partnership to design, develop and deliver solutions for some of the most pressing challenges faced by organizations engaged in commodity hedging, trading and risk management.

The partnership will leverage their complementary geographic, technical and strategic capabilities to jointly offer world-class solutions and services to energy and commodity producers, end-users, marketers, distributors and traders.

Tamir Druz, Capra Energy’s director, said: “NQuantX is the ‘Go-To Firm’ when it comes to state-of-the-art solutions in the field of energy and commodity trading and risk management analytics.  By coupling NQuantX’s sophisticated capabilities with Capra Energy’s expertise in developing and implementing advanced commodity strategies, we expect to deliver truly extraordinary new products to our clients.”

Carlos Blanco, NQuantX managing director, said: “We are excited to bring our clients a competitive advantage navigating today’s complex and volatile energy and commodity markets by integrating Capra Energy’s extensive practical experience in hedging, trading and risk management to offer a wide range of risk management resources and independent advice.”

Their first collaborative offering is the Hedging Strategy OptimizerTM, a system for simulating alternative hedging strategies and evaluating their effectiveness in achieving risk-adjusted performance targets.

About NQuantX and Capra Energy
NQuantX is a leading US-based developer of decision support tools for commodity trading and risk management, with flagship products such as NQXL Global Commodity Workbench and NQXL Risk.  It is led by Dr. Carlos Blanco, a pioneer and globally-recognized expert in the field of energy and commodity-related financial engineering. 

Capra Energy is based in Asia, and is a strategy-focused, energy trading and risk management consulting firm.  It is led by Tamir Druz, a leading practitioner in commodities strategy development for corporate consumers, producers and processors, as well as financial investors.

Please contact us at:
Carlos Blanco
Tamir Druz

The following table contains a detailed breakdown of hedging activity by industry:
The level of activity in the following industries was minimal (below 5%): Retailing, Pharmaceuticals, Software Services, Technology Hardware & Equipment and Semiconductors.

The commodity hedging programs in the most active industry (Metals & Mining) were most often focused on managing exposure to raw materials.  Energy risk management (natural gas, diesel fuel, etc.) was a focus of most of these companies' programs as well, but not quite to the same extent.  In Shipping & Transportation, commodity hedging was almost exclusively focused on energy risk management (e.g., diesel, jet fuel, marine fuel).

Other major findings included:
  • Over 60% of commodity hedging programs used only linear instruments (swaps, futures, forwards), while fewer than 10% used only options (financial or physical): 
  • The vast majority of companies with active or passive commodity hedging programs (>95%) were using hedge accounting for their hedge positions (to the extent possible given the measured effectiveness).
We have just completed our Commodity Hedging Activity Survey, in which we researched the commodity hedging practices of almost two hundred of the largest corporations in the US and Europe.  Our sample was comprised of commercial and industrial firms that are not directly involved in commodity production or transportation, or in the processing of raw materials into higher value commodities. 

The first question we explored was the following: "Is there an active or passive commodity hedging program in place?"  What we found was that the single most important determinant of the likelihood that any given company has a commodity hedging program in place is whether or not it is in a 'commodity-intensive' industry.  Commodity-intensive industries are those in which commodity price fluctuations are a key driver of operating margin volatility.  Commodity expenses typically comprise anywhere between 5% and 40% of operating expenses for such businesses, which include shippers, steel producers and food processors.  Most firms (60%) in commodity-intensive industries hedge their commodity exposures, while most of the firms (75%) in other industries do not hedge their commodity risk. 
We also found that, regardless of the industry group, when there is a commodity program in place, it tends to be 'active' rather than just 'passive.'  The former implies that commodity hedging is a regularly occurring activity that occurs in conjunction with and in addition to operating practices like fixed price supply agreements.  Passive hedgers, on the other hand, tend to hedge infrequently, or exclusively within their procurement or sales agreements. 

We delved into a number of additional areas, such as which commodities are being hedged, which instruments are being traded and whether or not hedge accounting is being used.  We hope to provide more information in a future  post in our journal.
With the benefit of hindsight, we now know that had Air France-KLM maintained their fuel hedging strategy, they would have recouped the losses they suffered in the wake of the oil market crash in the second half of 2008, when Brent crude collapsed from a high of $144/bbl in mid-July to a price of just $36/bbl by year's end.  But spot Brent climbed back up over the next three years: to $78/bbl by the end of 2009, $93/bbl by the end of 2010, and $108/bbl by the end of 2011.  And had Air France continued its strategy of hedging a large, constant percentage of its fuel needs four years out, and rolling the hedge forward over time, its hedge portfolio would have fully participated in the recovery.  But instead, Air France-KLM restructured its program in late 2009, dramatically reducing both the time horizon and size of its hedge portfolio, and failing, as a result, to protect its operating margins from the steep rise in fuel prices that followed.

While the constant-percentage, rolling hedge strategy that Air France-KLM and many other firms have used is usually better than opportunistic, non-systematic strategies, it is far from best practice.  A much superior approach recognizes the tendency of company operating margins to return to sustainable long-term levels; in other words, best practice hedging exploits the observable mean-reverting behavior of operating margins.  When operating margins are well above long-term equilibrium levels, it makes good economic sense to try and preserve those performance levels for future periods, as Southwest Airlines famously did when oil prices were dramatically lower.  This is done by increasing the size and horizon of the hedge portfolio during periods of very healthy margins, while reducing hedge positions when margins are below average levels.  This is just one important feature of a best practice commodity hedging system, which is, unfortunately, lacking in the case of constant-percentage hedgers.

To demonstrate the significant difference between a conventional strategy like the one Air France-KLM used and the results that would have been realized by using a best practice hedging system, we simulated historical results for a constant-percentage hedging strategy (similar to the one Air France-KLM used) and compared them to those produced by our proprietary hedging system.  We used volumetric quantities based on Air France-KLM's fuel consumption (approximately 40 million bbls/year), and assumed that the constant-percentage hedge was set at 50% of exposure for a period of two years forward.  Our proprietary system used a variable hedge percentage based on inputs that would have been observable at each point in time (i.e., no future information was used).
As is evident from the chart above, while our proprietary hedging system avoided the extreme mark-to-market losses of the constant-percentage system, it still managed to participate in the bulk of the gains experienced during profitable quarters.  This rightward skew in results, accompanied by a narrowing of their distribution, is clearly evident when comparing the average hedge portfolio P&L results and their standard deviations for the two systems (results in $000's):
Our proprietary system was more than three times as profitable as the constant-percentage system.  In spite of this, our system exhibited almost half the level of quarterly risk observed in the constant-percentage system. 

We have observed similar results to these across commodity-intensive companies and industries.  To us, they are clear evidence of the fact that there is a better way to hedge than what most companies are still doing.  And while Air France-KLM may have scaled down its hedging program, we have seen little evidence that its hedging debacle has resulted in a move toward a best practice system.