Wednesday, April 25, 2007

Trouble Hedging Oil Prices: West Texas Crude

Monday's Wall Street Journal contained a sleeper of an article about the behavior of West Texas crude as oil's benchmark pricing instrument.

While the details of how and why this type of oil has become the instrument on which hedging instruments are built may be rather dull, it turns out that they are important. For, recently, the price of West Texas crude, and the hedging vehicles built upon it, have been moving in the opposite direction from the prices of the bulk of oil traded on world markets.

It goes to show, once again, that hedging is typically built on historical pricing behaviors, but is not always a lock. Right now, airlines and other major institutional consumers of energy hedges are seeing those financial insurance policies double down the wrong way. Instead of offsetting oil's price rise, the West Texas hedges are adding to the damage.

We saw this nine (has it been that long already?) years ago, when the wizards at John Merriwether's Long Term Capital Management, including two Nobel Laureates, misunderstood the behavioral assumptions they had made regarding various instruments used for hedging, and took them, instead, as tautological relationships. When a combination of market forces, including a Russian default, upset past relationships between the financial instruments, LTCM began its four month slide into bankruptcy and dissolution.

Now, we have a view of something similar, although simpler, occurring. The physical site chosen for delivery of West Texas crude-based derivatives is Cushing, Oklahoma. For a variety of reasons, the storage facilities in Cushing are full, thus depressing prices.

So, while attempts are being made to develop new benchmark oil instruments for other grades of crude, in other locations, let's not lose sight of the underlying lesson from this situation.

Relationships between financial instruments are observed behaviors within certain contexts. They are not laws, nor tautological truths. There can be occasions when conditions will be violated, relevant ranges of underlying or associated phenomena may be exceeded, and the relationships upon which hedges built with these financial instruments will fail to behave as expected.

It happened with "portfolio insurance" in the early 1990s. It happened again in 1998. It might be happening again now.

And it's almost certain to happen again, in some instruments, in the future.

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