Alberta should hedge its resource revenues
There is a way to tame energy-market volatility
by Michael Ganley
The Alberta government posted a $6.4-billion deficit in fiscal 2015-16, and is predicting a final deficit of almost $11 billion this year. This in a province that had no debt in early 2015. While it still has one of the strongest balance sheets in the country, the numbers illustrate the ongoing problem of the province’s heavy reliance on the crack cocaine of the fiscal world: resource revenues. They made up 30 per cent of the province’s revenue in 2011-12 and have averaged 26 per cent over the past 35 years. In real terms, resource revenues plummeted $6.5 billion last year, and made up just 5.7 per cent of total revenues. It’s no way to run a budget.
But how to get off the roller coaster? Diversify the economy, sure, if possible, but there’s no denying the power exerted by the province’s natural endowment. Alberta has tried a rainy day contingency fund, but that is subject to political expediency and is expected to be drained this year.
Tim Pickering, founder and president of Calgary’s Auspice Capital, says there is a better way. He points to the Mexican government, and says Alberta should follow its lead and develop a long-term hedging strategy for its oil and gas assets. “The fact that our government doesn’t take a hard look at how to hedge our production, or in the case of royalties, how to mitigate that downside risk, is absolute ignorance,” he says. “It is entirely solvable and it’s not overly complex, but no government has had the courage to do it.”
Mexico has been spending about US$1 billion a year over the past decade on its program. It made US$5 billion from its hedge book in 2008 and US$6.4 billion last year. The years in between saw no end payouts, but over the last decade it has spent about US$10 billion in put premiums and received a payout of US$15 billion. That’s a great result but, as Pickering says, a hedge program is not about making money. It’s about evening out cash flows and protecting the province against downside risks. “In each of those years [Mexico] knew that a minimum floor price was established on a significant component of their resource revenue.” It would allow the province to plan and fund its expenses with greater certainty from year to year.
Alberta has considered a hedge program in the past and has always avoided one, preferring to go with the contingency fund. But the reasons are best described as political, not financial. No politician wants to be seen sending big cheques to financiers when oil prices are high. To combat this perception, Pickering recommends a “mechanistic” approach to hedging. Mexico’s program starts several months prior to the hedge period. “A mechanistic approach makes it much more difficult for the media and critics of the program to make hindsight statements like ‘Mexican government suffers huge losses on the back of oil bets gone wrong,’” he says. “They are not ‘bets,’ they are insurance.” And like insurance on your house, it might look like a waste of money. Until you need it.
Now, with low oil prices, is not the time to start a hedging program. But when they next tick back up, the government would be wise to begin the process.