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 extreme as the decline in natural gas prices between the autumn of 2008 and the autumn 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 relates 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 financial 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
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 investors 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 exposure to declining prices while retaining exposure to increasing prices. The key to a successful hedging program 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 instruments, which could include swaps, collars, put options and three-way options. Among the findings of our 2009 hedging study, which included surveying executives of 38 independent oil and gas
FIGURE 1 Historical U.S. Crude Oil and Natural Gas Prices
producers, 41 percent of the participants reported they regularly hedged their production, while 29 percent said their companies never hedged their production. Of the firms that reported hedging on a regular basis, they typically hedged 5171 percent of their proved, developed and producing reserves. Swaps and collars were the most popular 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 environment. 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 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 actions that could prevent or mitigate similar situations in the future. A few of the key hedging lessons include: • The structure of hedges is important. There are significant differences in strategies 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
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 company’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 understand 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
FIGURE 2A Crude Oil Forward Price Curve
FIGURE 2B Natural Gas Forward Price Curve
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 experienced significant hedging losses (not to be confused with mark-to-market losses), there have been numerous companies–including many oil and gas producers–that have experienced significant financial problems as a result of poor hedging strategies or credit issues with counterparties. 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 company. 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 (ceiling) 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 additional 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 negligible 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 “knockin” or “knock-out” options, are rarely, if ever, true cash flow or economic hedges. That said, these structures have been successfully marketed over the past few years to producers as an aggressive, but sound, hedging strategy. How a chief financial officer can explain and justify a knock-in or knock-out option to shareholders or debt holders is an entirely different question. The bottom line is that while hedging crude oil and natural gas need not be a complex undertaking, it requires thoroughly 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 consumers? Figures 2A and 2B show the forward price curves for oil and gas, respectively. 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. Furthermore, while the 12-month strip is about $4.25/MMBtu, the 24-and 36month strips are not significantly higher at $4.65 and $4.85/MMBtu, respectively. Many gas producers believe the most difficult question facing their businesses is whether the fundamentals will push natural gas prices higher in the near future. However, 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 management 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 tolerance 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 instruments it should consider employing in any given market environment. As it relates to hedging and risk management, 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 exceptions (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 accurately 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 future 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, predicting prices always will be a very difficult and risky undertaking, given all the variables 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 management challenges to the industry. Producers would be well served to create and implement proper hedging and risk management 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 uncertain 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.