Wednesday, November 5, 2008

The Propane to Crude Spread Gone Really, Really Wrong

Atlas Pipeline Partners reports 3q08 earnings. Lookie here at one of the disclosures (bold emphasis mine):
The Partnership's financial results for the third quarter 2008 include a $71.5 million cash derivative expense resulting from the completion of the early termination of approximately 85% of its crude oil derivative contracts that it entered into as proxy hedges for the prices it receives for the ethane and propane portion of its NGL equity volume. The Partnership funded this transaction through its June 24, 2008 sale of 7,140,000 common units for aggregate net proceeds of approximately $262.1 million, including a capital contribution of approximately $5.4 million from its general partner to maintain its aggregate 2% general partner interest in the Partnership. These hedges...became less effective as a result of significant increases in the price of crude oil and less significant increases in the price of ethane and propane. The Partnership terminated these derivative contracts during June and July 2008 at an aggregate net cost of approximately $264.0 million. The Partnership's $71.5 million cash derivative expense recognized during the third quarter 2008 resulted from July 2008 net payments of $93.6 million to terminate the remaining portion of these derivative contracts. The attached hedge schedule reflects the current hedge position of the Partnership, adjusted for the crude oil derivative contracts that were terminated in June and July 2008. As a result of the termination of these hedge contracts, the Partnership's future cash flow should more accurately reflect the revenues generated from its ethane and propane volumes produced in its natural gas processing operations.
Translation: Propane and Ethane are hard to hedge (due to liquidity), and there's lots of data showing that these commodities trade in a relationship with crude. So Atlas did a little cross commodity hedging (sometimes called a "dirty" hedge). But the correlation broke down this year, and they incurred significant unexpected losses as the percentage of propane and ethane to crude got hammered in the extreme volatility.

Price correlations have been breaking down everywhere in the energy sector this year. (As I have written in previous blog posts, Nasim Taleb is not surprised.) More on the breakdown of price correlations in an upcoming post. Interestingly, had management not busted those trades when they did, the losses would have come close to doubling. My philosophy professor always told me: "correlation does not imply causation." Likewise, Warren Buffett cautions to "be wary of geeks bearing models."

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