lev-os Analyzing Commodity Price Risk
Evaluates commodity price exposure with forward curve analysis, hedging strategies, and break-even price sensitivity.
When To Use
- Assessing a portfolio's or project's exposure to commodity price movements (crude oil, natural gas, metals, agricultural products)
- Designing or reviewing a hedging program for a producer, refiner, or offtaker
- Stress testing price assumptions in investment underwriting or reserve-based lending
- Evaluating forward curve shape (contango vs. backwardation) and its impact on roll yield and storage economics
- Benchmarking realized vs. budgeted commodity prices for variance analysis
Inputs To Gather
- Commodity exposure profile: volumes, commodity type(s), production/consumption schedule, contract tenors
- Current and historical spot prices: at minimum 3–5 years of price history for the relevant benchmark (e.g., WTI, Henry Hub, LME Copper)
- Forward/futures curve data: exchange-settled strip prices across relevant tenors
- Existing hedge book: instruments in place (swaps, collars, puts, three-way structures), notional volumes, strike prices, expiration dates
- Break-even economics: all-in sustaining cost, lifting cost, or full-cycle cost per unit of production [VERIFY against operator's cost model]
- Counterparty and credit terms: ISDA status, margin/collateral requirements, hedge line availability
- Regulatory or covenant constraints: any hedging ratio limits from lenders or board-approved risk policy [VERIFY applicable policy]
Workflow
Map the exposure: Quantify gross unhedged volume by commodity, time period, and delivery point. Identify basis risk between the production/consumption location and the benchmark index.
Analyze the forward curve: Pull current futures strip and compare to trailing 3-year and 5-year averages. Note whether the curve is in contango or backwardation and assess implications for hedge timing and roll costs.
Evaluate existing hedges: Overlay the current hedge book on the exposure profile. Calculate the percentage hedged by quarter, the weighted-average hedge price, and the mark-to-market value of outstanding positions.
Run price scenarios:
- Base case: strip pricing as of analysis date
- Downside: price decline of 25–40% sustained over 12 months (calibrate to historical drawdowns)
- Upside: price rally of 20–30% (to quantify opportunity cost of hedges)
- Stress case: a tail event (e.g., 2008 or 2020 crude collapse) applied to the current portfolio
- For each scenario, compute revenue impact, debt service coverage, and covenant compliance.
Assess break-even sensitivity: Determine the commodity price at which the project or portfolio hits cash-flow breakeven, debt service breakeven, and economic breakeven (including return hurdle). Flag any scenario where price falls below breakeven for more than two consecutive quarters.
Recommend hedging strategy: Based on risk tolerance, cost of hedging, and forward curve shape, recommend an instrument mix:
- Swaps for certainty of cash flow (fixed price, full participation lock)
- Costless collars for floor protection with upside participation
- Put options for downside protection while retaining full upside (premium cost required)
- Three-way collars to reduce or eliminate premium by selling a deeper put
- Specify recommended hedge ratios by tenor (e.g., 75% of PDP production for 12 months, 50% for months 13–24) [VERIFY against lender or board policy constraints]
Document basis risk: If the production point differs from the hedge benchmark, quantify historical basis differential volatility and recommend basis swaps or location differentials if material.
Output
Produce a Commodity Price Risk Report containing:
- Executive summary: one-paragraph overview of net exposure, key risk, and recommended action
- Exposure map table: gross and net (post-hedge) volumes by commodity, quarter, and delivery point
- Forward curve chart: current strip vs. historical averages with break-even price overlaid
- Scenario analysis table: revenue, EBITDA, and DSCR under base, downside, upside, and stress cases
- Break-even waterfall: chart showing all-in cost buildup per unit vs. current strip price
- Hedge recommendation summary: instrument type, notional volume, tenor, indicative pricing, and estimated cost/premium
- Risk register: residual risks (basis risk, volumetric risk, counterparty credit, liquidity risk) with severity rating
Quality Checks
- Confirm that forward curve data is sourced from a recognized exchange or broker dealer and is dated within 2 business days of analysis
- Verify that hedge ratios do not exceed any covenant or policy ceiling [VERIFY]
- Ensure break-even costs are consistent with the operator's most recent cost report or reserve report
- Check that scenario magnitudes are calibrated to actual historical drawdowns, not arbitrary round numbers
- Validate that mark-to-market calculations use consistent valuation methodology (mid-market vs. bid/ask)
- Confirm that basis differential assumptions reflect the correct delivery point and index pairing
- Flag any commodity where liquidity in the futures market is thin beyond the recommended hedge tenor