The Risk Oil Drillers Couldn’t Hedge Away To provide themselves a cushion against sharp drops in oil prices, drilling companies often buy hedges—financial contracts that pay off when prices fall. Now a quirk of bankruptcy law has stripped some shale drillers of that insurance just when they need it most. Houston-based Linn Energy, for example, bought contracts that guaranteed a price of $90 a barrel, even if prices were lower. It paid off: By the end of March, with oil below $45 a barrel, Linn’s hedges were worth $1.5 billion, making them among the company’s most valuable assets. The hedges weren’t enough, however, to keep Linn out of financial trouble after the oil price plunge. This put Linn’s lenders, a syndicate of more than 20 companies, in an odd position. Linn owed them $4 billion and was about to go into bankruptcy. Yet some of those same lenders—it’s not clear which ones—were also on the other side of Linn’s hedges, paying $100 million per month to Linn to settle the contracts as they came due. Put simply, Linn’s bankers had two losing bets at once. Then came the solution. In the weeks leading up to Linn filing for bankruptcy protection in May, its oil and gas hedges were sold off for their market value. The resulting $1.2 billion in cash was applied to paying off its loans. Linn agreed to the sale, but if it hadn’t, bankruptcy law would have allowed the lenders to seize the contracts anyway.... http://www.bloomberg.com/news/articles/2016-07-21/the-risk-oil-drillers-couldn-t-hedge-away
Interesting article.. So he basically underhedged? He should have had 3x the size... Over the counter trades are risky, always have settlement risk etc. and can usually not be traded with other parties except the client/issuer. You could do the same trade in opposite direction and be hedged, but when one of your counterparties fails you're fucked. That's a massive risk. I remember when Lehman went bust we had some trades in options and underlying that still needed to settle (t+2) and some were cancelled. You don't know what you have for a few days. For us it worked out okay, I think we made a 100 grand on it by missing out on a hedge. Wouldn't want to be in that position again.