Hedgers—Disillusioned with Complicated Bilateral Structures: An Interview with Jonathon Kornafel

Jonathan Kornafel
Posted: 02/10/2010

Jonathan Kornafel, Director of Asian Operations for Hudson Capital Asia, speaks exclusively to Oil and Gas IQ about hedging strategies and risk exposures that many oil and energy companies are facing.

When it comes to hedging strategies for fuel risk exposure, what are some of the challenges that many companies are facing?

There are a number of challenges for any consumer or producer in attempting to hedge their fuel risk exposure. Aside from the obvious technical items such as tenor and structure, the more difficult items on which to reach a conclusion include liquidity, basis risk and clearing vs. over-the-counter (otc).

As a long-time trader and market-maker, I must stress liquidity as an overriding concern. Not only for hedgers looking to simply enter into a hedge which they will then hold until expiration, but also for those who like to enter and exit trades as their underlying exposure fluctuates. Liquidity and basis risks are certainly entwined. While opting for an illiquid hedge in an over-the-counter market, the hedger is often giving up enormous levels of "edge" in order to enter or exit the trade. This is relative to the amount of "edge" it costs to enter or exit a trade in a highly liquid and competitive market. While there are often a number of concerns at stake (hedge accounting, etc.), if there exists a highly liquid alternative to the underlying and this alternative is highly correlated to the physical risk, the hedger would not be performing his or her duty if they did not at least examine the positives and negatives of using the more liquid market while bearing some basis risk.

Obviously, posting margin on an exchange and the inherent risks of margin calls is an issue that needs to be weighed against the counterparty risk of the otc markets.

Why is there no clear solution for these problems?

There is no solution to the problems cited above because the answers vary for each hedger depending on cash and credit availability as well as internal risk management requirements. These internal risk management requirements are often the result of external accounting regulations.

What are some of the key issues that arise from long and short term volatility dynamics?

Typically, implied volatility manifests itself among average hedgers in the form of increasing or decreasing the cost of call and put options. The call and put skews can increase or decrease often without the underlying commodity moving at all. This is often the result of a hedger entering the market with a large order, or a particular bias prevalent amongst market-makers and traders for the direction the underlying will be moving in the future.

In your opinion what are some of today’s hedging trends?

As a result of large hedges being applied by consumers at or near the heights reached in 2008, many hedgers have become disillusioned with complicated bilateral structures. As a result, many have moved towards simplifying their hedging strategies. The result has been more buying of swaps, futures, calls and simple call spread structures on the cleared markets.

Kornafel is speaking at the Oil & Energy Price Risk Management summit, about hedging risks in today’s marketand will be a panelist on the "To hedge or Not to Hedge" panel discussion. Learn more here.

Jonathan Kornafel
Posted: 02/10/2010

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