OCTOBER 2010

The “Better Business” Publication Serving the Exploration / Drilling / Production Industry

Hedging Mitigates Price Risk Exposure

By Michael Corley U.S. crude oil and natural gas prices producers, 41 percent of the participants
since the first quarter of 2003, as well as reported they regularly hedged their pro-
HOUSTON–While not nearly as ex- the separation between oil and gas prices duction, while 29 percent said their com-
treme as the decline in natural gas prices on a Btu equivalent basis. panies never hedged their production. Of
between the autumn of 2008 and the au- Many producers, and often their in- the firms that reported hedging on a
tumn of 2009 when the recession was vestors as well, usually elect not to hedge regular basis, they typically hedged 51-
wrecking the nation’s economy, the decline because they believe it will reduce their 71 percent of their proved, developed
from $6.00 to $4.00 an MMBtu has sent upside, should prices increase significantly. and producing reserves.
a clear message to gas producers as it re- Some hedges are, in fact, structured in Swaps and collars were the most pop-
lates to hedging. such a way that reduces the producer’s ular hedging instruments utilized among
Hedging has become a fundamental potential upside, but there are hedging study participants. Surprisingly, only 34
strategic decision for many oil and gas strategies that mitigate or eliminate ex- percent of the participants indicated that
companies, and is the only sound way a posure to declining prices while retaining establishing stable and predictable cash
producer can significantly reduce its fi- exposure to increasing prices. flow was the most important goal of their
nancial exposure to volatile oil and gas The key to a successful hedging pro- hedging activities. Sixty-seven percent of
prices. However, many companies still gram is developing and implementing the participants characterized the success
choose not to hedge their price risk, strategies that perform as intended in of their company’s current and past hedging
which is understandable considering that both high- and low-price environments, initiatives as good or excellent.
without proper analysis and planning, as well as in between. That typically
hedging can create as many challenges means utilizing a combination of instru- Lessons To Learn
as it is intended to solve. ments, which could include swaps, collars, Depending on a company’s perspective
With spot gas prices falling back to put options and three-way options. and experience, hedging can be either a
$4.00/MMBtu, producers that are not Among the findings of our 2009 hedg- blessing or a curse. Both reputations are
hedged are in almost the same predicament ing study, which included surveying ex- well deserved. The past few years have
as last summer and fall. Figure 1 shows ecutives of 38 independent oil and gas shown that there are several lessons to be
learned regarding oil and gas hedging.
FIGURE 1 The extent to which producers, as well
as their bankers and investors, learn from
Historical U.S. Crude Oil and Natural Gas Prices
these lessons and act accordingly will
only be told in time.
However, the industry should not be
quick to forget how close many producers
came to facing serious financial problems,
or worse, as a result of a low-price envi-
ronment. Furthermore, if natural gas
prices do not reverse course in the coming
weeks and months, many producers could
once again find themselves in a difficult
position.
While the energy markets often are
shocked by events such as the bankruptcy
filing of SemGroup LP, which lost billions

Reproduced for Mercatus Energy Advisors LLC with permission from The American Oil & Gas Reporter
www.aogr.com
SpecialReport: Natural Gas Markets

as a result of being on the wrong side of their banks or trading counterparts to company recommends them as a sound
the crude oil market in 2008, it is not provide optimal hedging strategies. Banks hedging strategy.
clear that many of the lessons that might and trading companies take the opposite Make no mistake, these issues are not
have been learned from these events have side of a producer’s hedge transactions, limited to oil and gas producers. Both
actually been translated into concrete ac- which means the bank or trading compa- major corporations, as well as government
tions that could prevent or mitigate similar ny’s best interest may not necessarily entities, have been pushed to the brink of
situations in the future. align with the best interests of the producer. bankruptcy because they engaged in highly
A few of the key hedging lessons in- It is fine to listen to the hedging strategies speculative trading–masked as hedging–
clude: being marketed by trading desks, since without understanding the full implications
• The structure of hedges is important. they often can generate good ideas and of their hedge positions. Furthermore,
There are significant differences in strate- meaningful discussions. On the other while the media has focused on a handful
gies that are critically important, such as hand, simply accepting the exact trade of high-profile companies that have ex-
basis and credit risk, but are often entirely that is being suggested by the bank or perienced significant hedging losses (not
overlooked by many producers,. trading company is rarely in the producer’s to be confused with mark-to-market loss-
• So-called exotic hedging strategies best interest. es), there have been numerous compa-
can lead to a financial disaster if the As seemingly obvious as these lessons nies–including many oil and gas produc-
strategies are not completely understood are, many producers do not fully under- ers–that have experienced significant fi-
by the management team. stand their hedge positions. Few producers nancial problems as a result of poor hedg-
• Producers must “stress test” their run in-depth models to determine what a ing strategies or credit issues with coun-
hedge positions to understand the financial hedge position or portfolio will do under terparties.
consequences of both individual positions, various market conditions. Furthermore,
as well as their entire hedge portfolios, many producers are surprised to learn Costless Collars
in various market scenarios. These tests that it is crucial to update and analyze Oil and gas producers would benefit
should not only include price risk, but these models on a regular basis. Likewise, greatly if they would challenge the myth
basis, credit and operational risk as well. few producers shy away from aggressive that costless collars are the holy grail of
• Producers should not depend on “lottery” hedges if a major bank or trading hedging. Costless collars, if not properly
monitored and dynamically hedged, can
FIGURE 2A expose producers to significant long-term
Crude Oil Forward Price Curve risks that can potentially destroy a com-
pany.
Imagine a crude oil producer in late
December 2008, when the New York
Mercantile Exchange prompt-month West
Texas Intermediate contract was trading
near $35.00 a barrel. Concerned that
crude oil prices would continue to decline,
the producer entered into a costless collar
consisting of a $27.50/bbl put option
(floor) and a $47.50/bbl call option (ceil-
ing) for the 2009 calendar year. With
NYMEX WTI prices averaging $62.00/bbl
in 2009, the producer would have left
$14.50/bbl on the table, not to mention
tying up a significant amount of its credit
FIGURE 2B facility until the positions expired at the
Natural Gas Forward Price Curve end of the year.
If this company had received sound
hedging advice, it most likely would have
purchased an outright put option, or at the
very least, utilized a three-way option that
would have included purchasing an addi-
tional call option with a higher strike price
to mitigate the exposure of being short
the $47.50 call option (ceiling).
In retrospect, it is easy to Monday
morning quarterback such a situation,
but if this company had taken the time to
run a proper statistical model prior to
initiating a costless collar, the modeling
would have shown, without a doubt, that
SpecialReport: Natural Gas Markets

purchasing outright put options was a derhedged natural gas producers. Fur- Some companies attempt to hedge only
much sounder strategy than entering into thermore, while the 12-month strip is when they “see good opportunities,” or
a costless collar. about $4.25/MMBtu, the 24-and 36- only when they have a strong opinion
While simply buying put options would month strips are not significantly higher about the market. The truth is, hedging
have required paying an upfront premium, at $4.65 and $4.85/MMBtu, respectively. decisions should not be made solely, or
the cost of buying options is often negli- Many gas producers believe the most dif- even mostly, based on one’s view of future
gible when compared with the risk incurred ficult question facing their businesses is price movements. It is impossible to ac-
when a producer utilizes a costless collar, whether the fundamentals will push natural curately predict commodity prices. In
especially when the potential implications gas prices higher in the near future. How- keeping, producers should not attempt to
of the call option(s) going deep in the ever, we would argue that the ability to “selectively” hedge by hedging only when
money are not fully understood, not to manage risk tolerance and meet or exceed they think prices will fall and not hedging
mention the foregone opportunity cost. cash flow requirements, etc., should dictate when they believe prices will rise.
To clarify, costless collars are often a hedging decisions, and not the manage- Another dangerous approach is “all
sound hedging strategy for many oil and ment team’s opinion about future NYMEX or nothing” hedging, where a company
gas producers, but it is critical to fully prices. hedges either all of its production or
understand and properly quantify the Once a producer decides to develop a none of it based on its view of whether
risks associated with costless collars hedging program, one of the main issues prices will move up or down. In either of
before the confirmation sheet has been is identifying the best types of hedging these approaches, guessing wrong on fu-
signed, sealed and delivered. Other hedging instruments that will allow the company ture price directions can have a disastrous
strategies, including synthetic options, to meet its business objectives. The first impact on cash flows and profit margins.
participatory swaps, etc., can be similarly step is determining the organization’s tol- As producers know very well, predicting
problematic if not properly utilized and erance for risk as well as its hedging future oil and gas prices is a fool’s game.
fully understood. goals and objectives. What is the company No matter how sound the analysis, pre-
Another important point to consider seeking to accomplish by hedging? Is it dicting prices always will be a very difficult
to smooth volatile cash flows? Guarantee and risky undertaking, given all the vari-
is that the exotic hedging strategies that
a minimum revenue stream? How much ables that come into play.
have been marketed by banks and trading
upside is the company willing to give up The oil and gas industry always has
companies in recent years, such as “knock-
in order to reduce or eliminate exposure been a volatile and cyclical business, and
in” or “knock-out” options, are rarely, if
to low prices? the future is likely going to continue to
ever, true cash flow or economic hedges. Only after answering these, as well as present many hedging and risk manage-
That said, these structures have been suc- many related questions, should a producer ment challenges to the industry. Producers
cessfully marketed over the past few begin to determine what hedging instru- would be well served to create and im-
years to producers as an aggressive, but ments it should consider employing in plement proper hedging and risk man-
sound, hedging strategy. How a chief fi- any given market environment. agement policies, or review and reassess
nancial officer can explain and justify a As it relates to hedging and risk man- policies that are already in place, to make
knock-in or knock-out option to share- agement, there are a number of common certain they are mitigating their exposure
holders or debt holders is an entirely dif- mistakes that oil and gas companies need to price risk (as well as credit, regulatory,
ferent question. to avoid at all costs. First, it is crucial to operational and basis risk) in today’s un-
The bottom line is that while hedging remember that hedging should not be certain economic environment. r
crude oil and natural gas need not be a considered a source of income. A well
complex undertaking, it requires thor- designed hedging strategy should provide
oughly examining the company’s past cash flow and revenue certainty, the ability
hedging experiences as well as planning to lock in profit margins and/or protection
MICHAEL CORLEY is founder and
for the future with significant quantitative against declining prices. If a producing
president of Mercatus Energy Advisors
analysis. company initiates a hedging program in
LLC (formerly EnRisk Partners), a
order to generate profits, it has become a
Hedging Suggestions Houston-based energy trading and
speculator. While there are a few excep- risk management advisory firm. Prior
So with the start of the winter heating tions (such as trading around storage or to founding Mercatus Energy Advisors,
season around the corner, what is the transportation assets), speculating on he worked for several energy consulting
state of the natural gas market as it relates prices is not a form of hedging. firms, where he served as an energy
to hedging for both producers and con- The vast majority of hedging mistakes trading and risk management adviser
sumers? Figures 2A and 2B show the are the result of a poor or nonexistent to oil and gas producers, commercial
forward price curves for oil and gas, re- risk management policy, or the lack of a and industrial energy consumers, and
spectively. For natural gas, the one-year sound hedging strategy. Most hedging energy marketers. Earlier in his career,
forward strip (the average price of the mistakes can be avoided if the company Corley held various positions in trading,
first 12 months of NYMEX gas futures takes the time and makes the effort to structuring, scheduling and quantitative
contracts) is trading around $4.25/MMBtu, create a proper risk management policy analysis with El Paso Merchant Energy
which is near an eight-year low. and develop and implement strategies and Cantor Fitzgerald. He is a graduate
The forward curve obviously is not that allow it to meet its hedging goals of the University of Oklahoma.
very attractive to most unhedged or un- and objectives.