OCTOBER 2010
The “Better Business” Publication Serving the Exploration / Drilling / Production Industry
Hedging Mitigates Price Risk Exposure
By Michael Corley
HOUSTON–While not nearly as ex-
treme as the decline in natural gas prices
between the autumn of 2008 and the au-
tumn of 2009 when the recession was
wrecking the nation’s economy, the decline
from $6.00 to $4.00 an MMBtu has sent
a clear message to gas producers as it re-
lates to hedging.
Hedging has become a fundamental
strategic decision for many oil and gas
companies, and is the only sound way a
producer can significantly reduce its fi-
nancial exposure to volatile oil and gas
prices. However, many companies still
choose not to hedge their price risk,
which is understandable considering that
without proper analysis and planning,
hedging can create as many challenges
as it is intended to solve.
With spot gas prices falling back to
$4.00/MMBtu, producers that are not
hedged are in almost the same predicament
as last summer and fall. Figure 1 shows
FIGURE 1
Historical U.S. Crude Oil and Natural Gas Prices
Reproduced for Mercatus Energy Advisors LLC with permission from The American Oil & Gas Reporter
U.S. crude oil and natural gas prices
since the first quarter of 2003, as well as
the separation between oil and gas prices
on a Btu equivalent basis.
Many producers, and often their in-
vestors as well, usually elect not to hedge
because they believe it will reduce their
upside, should prices increase significantly.
Some hedges are, in fact, structured in
such a way that reduces the producer’s
potential upside, but there are hedging
strategies that mitigate or eliminate ex-
posure to declining prices while retaining
exposure to increasing prices.
The key to a successful hedging pro-
gram is developing and implementing
strategies that perform as intended in
both high- and low-price environments,
as well as in between. That typically
means utilizing a combination of instru-
ments, which could include swaps, collars,
put options and three-way options.
Among the findings of our 2009 hedg-
ing study, which included surveying ex-
ecutives of 38 independent oil and gas
www.aogr.com
producers, 41 percent of the participants
reported they regularly hedged their pro-
duction, while 29 percent said their com-
panies never hedged their production. Of
the firms that reported hedging on a
regular basis, they typically hedged 51-
71 percent of their proved, developed
and producing reserves.
Swaps and collars were the most pop-
ular hedging instruments utilized among
study participants. Surprisingly, only 34
percent of the participants indicated that
establishing stable and predictable cash
flow was the most important goal of their
hedging activities. Sixty-seven percent of
the participants characterized the success
of their company’s current and past hedging
initiatives as good or excellent.
Lessons To Learn
Depending on a company’s perspective
and experience, hedging can be either a
blessing or a curse. Both reputations are
well deserved. The past few years have
shown that there are several lessons to be
learned regarding oil and gas hedging.
The extent to which producers, as well
as their bankers and investors, learn from
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
SpecialReport: Natural Gas Markets
as a result of being on the wrong side of
the crude oil market in 2008, it is not
clear that many of the lessons that might
have been learned from these events have
actually been translated into concrete ac-
tions that could prevent or mitigate similar
situations in the future.
A few of the key hedging lessons in-
clude:
• The structure of hedges is important.
There are significant differences in strate-
gies that are critically important, such as
basis and credit risk, but are often entirely
overlooked by many producers,.
• So-called exotic hedging strategies
can lead to a financial disaster if the
strategies are not completely understood
by the management team.
• Producers must “stress test” their
hedge positions to understand the financial
consequences of both individual positions,
as well as their entire hedge portfolios,
in various market scenarios. These tests
should not only include price risk, but
basis, credit and operational risk as well.
• Producers should not depend on
FIGURE 2A
Crude Oil Forward Price Curve
FIGURE 2B
Natural Gas Forward Price Curve
their banks or trading counterparts to
provide optimal hedging strategies. Banks
and trading companies take the opposite
side of a producer’s hedge transactions,
which means the bank or trading compa-
ny’s best interest may not necessarily
align with the best interests of the producer.
It is fine to listen to the hedging strategies
being marketed by trading desks, since
they often can generate good ideas and
meaningful discussions. On the other
hand, simply accepting the exact trade
that is being suggested by the bank or
trading company is rarely in the producer’s
best interest.
As seemingly obvious as these lessons
are, many producers do not fully under-
stand their hedge positions. Few producers
run in-depth models to determine what a
hedge position or portfolio will do under
various market conditions. Furthermore,
many producers are surprised to learn
that it is crucial to update and analyze
these models on a regular basis. Likewise,
few producers shy away from aggressive
“lottery” hedges if a major bank or trading
company recommends them as a sound
hedging strategy.
Make no mistake, these issues are not
limited to oil and gas producers. Both
major corporations, as well as government
entities, have been pushed to the brink of
bankruptcy because they engaged in highly
speculative trading–masked as hedging–
without understanding the full implications
of their hedge positions. Furthermore,
while the media has focused on a handful
of high-profile companies that have ex-
perienced significant hedging losses (not
to be confused with mark-to-market loss-
es), there have been numerous compa-
nies–including many oil and gas produc-
ers–that have experienced significant fi-
nancial problems as a result of poor hedg-
ing strategies or credit issues with coun-
terparties.
Costless Collars
Oil and gas producers would benefit
greatly if they would challenge the myth
that costless collars are the holy grail of
hedging. Costless collars, if not properly
monitored and dynamically hedged, can
expose producers to significant long-term
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
facility until the positions expired at the
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
much sounder strategy than entering into
a costless collar.
While simply buying put options would
have required paying an upfront premium,
the cost of buying options is often negli-
gible when compared with the risk incurred
when a producer utilizes a costless collar,
especially when the potential implications
of the call option(s) going deep in the
money are not fully understood, not to
mention the foregone opportunity cost.
To clarify, costless collars are often a
sound hedging strategy for many oil and
gas producers, but it is critical to fully
understand and properly quantify the
risks associated with costless collars
before the confirmation sheet has been
signed, sealed and delivered. Other hedging
strategies, including synthetic options,
participatory swaps, etc., can be similarly
problematic if not properly utilized and
fully understood.
Another important point to consider
is that the exotic hedging strategies that
have been marketed by banks and trading
companies in recent years, such as “knock-
in” or “knock-out” options, are rarely, if
ever, true cash flow or economic hedges.
That said, these structures have been suc-
cessfully marketed over the past few
years to producers as an aggressive, but
sound, hedging strategy. How a chief fi-
nancial officer can explain and justify a
knock-in or knock-out option to share-
holders or debt holders is an entirely dif-
ferent question.
The bottom line is that while hedging
crude oil and natural gas need not be a
complex undertaking, it requires thor-
oughly examining the company’s past
hedging experiences as well as planning
for the future with significant quantitative
analysis.
Hedging Suggestions
So with the start of the winter heating
season around the corner, what is the
state of the natural gas market as it relates
to hedging for both producers and con-
sumers? Figures 2A and 2B show the
forward price curves for oil and gas, re-
spectively. For natural gas, the one-year
forward strip (the average price of the
first 12 months of NYMEX gas futures
contracts) is trading around $4.25/MMBtu,
which is near an eight-year low.
The forward curve obviously is not
very attractive to most unhedged or un-
derhedged natural gas producers. Fur-
thermore, while the 12-month strip is
about $4.25/MMBtu, the 24-and 36-
month strips are not significantly higher
at $4.65 and $4.85/MMBtu, respectively.
Many gas producers believe the most dif-
ficult question facing their businesses is
whether the fundamentals will push natural
gas prices higher in the near future. How-
ever, we would argue that the ability to
manage risk tolerance and meet or exceed
cash flow requirements, etc., should dictate
hedging decisions, and not the manage-
ment team’s opinion about future NYMEX
prices.
Once a producer decides to develop a
hedging program, one of the main issues
is identifying the best types of hedging
instruments that will allow the company
to meet its business objectives. The first
step is determining the organization’s tol-
erance for risk as well as its hedging
goals and objectives. What is the company
seeking to accomplish by hedging? Is it
to smooth volatile cash flows? Guarantee
a minimum revenue stream? How much
upside is the company willing to give up
in order to reduce or eliminate exposure
to low prices?
Only after answering these, as well as
many related questions, should a producer
begin to determine what hedging instru-
ments it should consider employing in
any given market environment.
As it relates to hedging and risk man-
agement, there are a number of common
mistakes that oil and gas companies need
to avoid at all costs. First, it is crucial to
remember that hedging should not be
considered a source of income. A well
designed hedging strategy should provide
cash flow and revenue certainty, the ability
to lock in profit margins and/or protection
against declining prices. If a producing
company initiates a hedging program in
order to generate profits, it has become a
speculator. While there are a few excep-
tions (such as trading around storage or
transportation assets), speculating on
prices is not a form of hedging.
The vast majority of hedging mistakes
are the result of a poor or nonexistent
risk management policy, or the lack of a
sound hedging strategy. Most hedging
mistakes can be avoided if the company
takes the time and makes the effort to
create a proper risk management policy
and develop and implement strategies
that allow it to meet its hedging goals
and objectives.
Some companies attempt to hedge only
when they “see good opportunities,” or
only when they have a strong opinion
about the market. The truth is, hedging
decisions should not be made solely, or
even mostly, based on one’s view of future
price movements. It is impossible to ac-
curately predict commodity prices. In
keeping, producers should not attempt to
“selectively” hedge by hedging only when
they think prices will fall and not hedging
when they believe prices will rise.
Another dangerous approach is “all
or nothing” hedging, where a company
hedges either all of its production or
none of it based on its view of whether
prices will move up or down. In either of
these approaches, guessing wrong on fu-
ture price directions can have a disastrous
impact on cash flows and profit margins.
As producers know very well, predicting
future oil and gas prices is a fool’s game.
No matter how sound the analysis, pre-
dicting prices always will be a very difficult
and risky undertaking, given all the vari-
ables that come into play.
The oil and gas industry always has
been a volatile and cyclical business, and
the future is likely going to continue to
present many hedging and risk manage-
ment challenges to the industry. Producers
would be well served to create and im-
plement proper hedging and risk man-
agement policies, or review and reassess
policies that are already in place, to make
certain they are mitigating their exposure
to price risk (as well as credit, regulatory,
operational and basis risk) in today’s un-
certain economic environment. r
MICHAEL CORLEY is founder and
president of Mercatus Energy Advisors
LLC (formerly EnRisk Partners), a
Houston-based energy trading and
risk management advisory firm. Prior
to founding Mercatus Energy Advisors,
he worked for several energy consulting
firms, where he served as an energy
trading and risk management adviser
to oil and gas producers, commercial
and industrial energy consumers, and
energy marketers. Earlier in his career,
Corley held various positions in trading,
structuring, scheduling and quantitative
analysis with El Paso Merchant Energy
and Cantor Fitzgerald. He is a graduate
of the University of Oklahoma.