Petroleum and gas producers’ choice to hedge utilizing varieties of hedging activities needs to be executed based on individual cases. For example, over-the-counter (OTC) transactions can be verified physically or financially (Nossa et al. 2016). The arrangement is generally defined in a master type agreement, and any purchase documentation is inscribed into it. One of the most extensively used variety of oil and gas OTC contracts is the Master Agreement issued by the International Swaps and Derivatives Association, Inc. (ISDA) (Nossa et al. 2016). ISDA’s structure permits parties to participate in physical and financial activities within one agreement.
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Master netting can be interpreted in two ways within the ISDA Master Agreement. Payment netting is utilized during the regular company of a catalyst firm. It requires balancing cash flow responsibilities among two parties on a contracted day and a particular currency into a single net payable or receivable (International Swaps and Derivatives Association, 2019). Another type is called close-out netting, which refers to the netting of transactions when the Master Agreement is terminated. In specific situations, the parties may be authorized to retrieve from transactions under the Master Agreement. It describes how the process of termination occurs and is carried out.
Various methods can be utilized to allow petroleum and gas producers to ensure their obligations within the ISDA Master Agreement. Thus, ISDA has a range of specific and predefined collateral requirements. The Credit Support Annex (CSA) that is responsible for the exchange and management of collateral and can be used to secure a party’s payment obligations. This is done with or without a lien on its assets as part of the ISDA Master Agreement (Nossa et al. 2016). Paragraph 13 of the CSA includes terms in regards to the varieties of collateral that can be utilized, the application of collateral by the secured party, and the return of collateral.
Over-the-counter (OTC) transactions are bilateral and are designed to fit each party’s distinct risk and monetary control procedures. These transactions enable the parties to set the precise intervals of their agreement; their personifications limit the participants’ capacity to transfer these contracts. OTC transactions are particularly valuable to petroleum and gas companies. They enable them to hedge all or some of their anticipated production considerably into the prospect than with exchange-traded operations (Nossa et al. 2016). This permits companies to standardize a hedge that is profoundly connected to the constant change of oil and gas prices, the essence of their reserves, and their market standard. Thus, the capacity to adjust all parts of an OTC transaction provides petroleum producer authority over the arrangement of hedging transactions.
Price adjustments often follow a pattern of swapping floating prices at predetermined intervals. In the petroleum case, a fixed price is switched for a floating price based on the agreed-upon amount (Nossa et al. 2016). The effective net price for petroleum production is locked at a fixed price. The benefit of such a way is that it allows for hedging of price risk and that many parties tend to be open to enter into such an agreement. Furthermore, this strategy increases the predictability of revenues.
Furthermore, swap agreements (known as swaps) are a bilateral type of contract. Swap counterparties trade an individual payment at every specified period, which is the net value owed by one contract member to another (Nossa et al. 2016). The swap agreement provides petroleum producers with various financial guarantees. It assures that the valid net cost for petroleum or gas production is secured at the set price accepted in the swap agreement and ensures the producer a constant, predictable, and steady monetary gain.
OTC contracts’ regularity has enabled parties to set terms that provide credit insurance in petroleum and gas transactions. In an oil price swap, the most considerable credit vulnerability the producer has to its counterparty is the determined oil value for every forthcoming month. This amount is multiplied by the notional quantity of the product for that month. This would happen if the named index went to zero for the rest of the term within the agreement.
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International Swaps and Derivatives Association. (2019). Legal Guidelines for Smart Derivatives Contracts: The ISDA master agreement. Web.
Nossa, D., Lotay, J., & Vrana, P. (2016). Hedging oil and gas production: Issues and considerations. Practical Law Finance, 2-13. Web.