By Michael Corley

HOUSTON–While not nearly as ex-treme as the decline in natural gas pricesbetween the autumn of 2008 and the au-tumn of 2009 when the recession waswrecking the nation’s economy, the declinefrom $6.00 to $4.00 an MMBtu has senta clear message to gas producers as it re-lates to hedging.Hedging has become a fundamental

strategic decision for many oil and gascompanies, and is the only sound way aproducer can significantly reduce its fi-nancial exposure to volatile oil and gasprices. However, many companies stillchoose not to hedge their price risk,which is understandable considering thatwithout proper analysis and planning,hedging can create as many challengesas it is intended to solve.With spot gas prices falling back to

$4.00/MMBtu, producers that are nothedged are in almost the same predicamentas last summer and fall. Figure 1 shows

U.S. crude oil and natural gas pricessince the first quarter of 2003, as well asthe separation between oil and gas priceson a Btu equivalent basis.Many producers, and often their in-

vestors as well, usually elect not to hedgebecause they believe it will reduce theirupside, should prices increase significantly.Some hedges are, in fact, structured insuch a way that reduces the producer’spotential upside, but there are hedgingstrategies that mitigate or eliminate ex-posure to declining prices while retainingexposure to increasing prices.The key to a successful hedging pro-

gram is developing and implementingstrategies that perform as intended inboth high- and low-price environments,as well as in between. That typicallymeans 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

producers, 41 percent of the participantsreported they regularly hedged their pro-duction, while 29 percent said their com-panies never hedged their production. Ofthe firms that reported hedging on aregular basis, they typically hedged 51-71 percent of their proved, developedand producing reserves.Swaps and collars were the most pop-

ular hedging instruments utilized amongstudy participants. Surprisingly, only 34percent of the participants indicated thatestablishing stable and predictable cashflow was the most important goal of theirhedging activities. Sixty-seven percent ofthe participants characterized the successof their company’s current and past hedginginitiatives as good or excellent.

Lessons To Learn

Depending on a company’s perspectiveand experience, hedging can be either ablessing or a curse. Both reputations arewell deserved. The past few years haveshown that there are several lessons to belearned regarding oil and gas hedging.The extent to which producers, as wellas their bankers and investors, learn fromthese lessons and act accordingly willonly be told in time.However, the industry should not be

quick to forget how close many producerscame to facing serious financial problems,or worse, as a result of a low-price envi-ronment. Furthermore, if natural gasprices do not reverse course in the comingweeks and months, many producers couldonce again find themselves in a difficultposition.While the energy markets often are

shocked by events such as the bankruptcyfiling of SemGroup LP, which lost billions

Hedging Mitigates Price Risk Exposure

FIGURE 1Historical U.S. Crude Oil and Natural Gas Prices

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

OCTOBER 2010

Reproduc ed for Mercatus Energy Advisors LLC with permission from The American Oil & Gas Reporter

www.aogr.com

as a result of being on the wrong side ofthe crude oil market in 2008, it is notclear that many of the lessons that mighthave been learned from these events haveactually been translated into concrete ac-tions that could prevent or mitigate similarsituations 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 asbasis and credit risk, but are often entirelyoverlooked by many producers,.

• So-called exotic hedging strategiescan lead to a financial disaster if thestrategies are not completely understoodby the management team.

• Producers must “stress test” theirhedge positions to understand the financialconsequences of both individual positions,as well as their entire hedge portfolios,in various market scenarios. These testsshould not only include price risk, butbasis, credit and operational risk as well.

• Producers should not depend on

their banks or trading counterparts toprovide optimal hedging strategies. Banksand trading companies take the oppositeside of a producer’s hedge transactions,which means the bank or trading compa-ny’s best interest may not necessarilyalign with the best interests of the producer.It is fine to listen to the hedging strategiesbeing marketed by trading desks, sincethey often can generate good ideas andmeaningful discussions. On the otherhand, simply accepting the exact tradethat is being suggested by the bank ortrading company is rarely in the producer’sbest interest.As seemingly obvious as these lessons

are, many producers do not fully under-stand their hedge positions. Few producersrun in-depth models to determine what ahedge position or portfolio will do undervarious market conditions. Furthermore,many producers are surprised to learnthat it is crucial to update and analyzethese 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 soundhedging strategy.Make no mistake, these issues are not

limited to oil and gas producers. Bothmajor corporations, as well as governmententities, have been pushed to the brink ofbankruptcy because they engaged in highlyspeculative trading–masked as hedging–without understanding the full implicationsof their hedge positions. Furthermore,while the media has focused on a handfulof high-profile companies that have ex-perienced significant hedging losses (notto 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 benefitgreatly if they would challenge the myththat costless collars are the holy grail ofhedging. Costless collars, if not properlymonitored and dynamically hedged, canexpose producers to significant long-termrisks that can potentially destroy a com-pany.Imagine a crude oil producer in late

December 2008, when the New YorkMercantile Exchange prompt-month WestTexas Intermediate contract was tradingnear $35.00 a barrel. Concerned thatcrude oil prices would continue to decline,the producer entered into a costless collarconsisting of a $27.50/bbl put option(floor) and a $47.50/bbl call option (ceil-ing) for the 2009 calendar year. WithNYMEX WTI prices averaging $62.00/bblin 2009, the producer would have left$14.50/bbl on the table, not to mentiontying up a significant amount of its creditfacility until the positions expired at theend of the year.If this company had received sound

hedging advice, it most likely would havepurchased an outright put option, or at thevery least, utilized a three-way option thatwould have included purchasing an addi-tional call option with a higher strike priceto mitigate the exposure of being shortthe $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 torun a proper statistical model prior toinitiating a costless collar, the modelingwould have shown, without a doubt, that

Natural Gas Forward Price Curve

FIGURE 2ACrude Oil Forward Price Curve

FIGURE 2B

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purchasing outright put options was amuch sounder strategy than entering intoa 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 incurredwhen a producer utilizes a costless collar,especially when the potential implicationsof the call option(s) going deep in themoney are not fully understood, not tomention the foregone opportunity cost.To clarify, costless collars are often a

sound hedging strategy for many oil andgas producers, but it is critical to fullyunderstand and properly quantify therisks associated with costless collarsbefore the confirmation sheet has beensigned, sealed and delivered. Other hedgingstrategies, including synthetic options,participatory swaps, etc., can be similarlyproblematic if not properly utilized andfully understood.Another important point to consider

is that the exotic hedging strategies thathave been marketed by banks and tradingcompanies in recent years, such as “knock-in” or “knock-out” options, are rarely, ifever, true cash flow or economic hedges.That said, these structures have been suc-cessfully marketed over the past fewyears to producers as an aggressive, butsound, hedging strategy. How a chief fi-nancial officer can explain and justify aknock-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 acomplex undertaking, it requires thor-oughly examining the company’s pasthedging experiences as well as planningfor the future with significant quantitativeanalysis.

Hedging Suggestions

So with the start of the winter heatingseason around the corner, what is thestate of the natural gas market as it relatesto hedging for both producers and con-sumers? Figures 2A and 2B show theforward price curves for oil and gas, re-spectively. For natural gas, the one-yearforward strip (the average price of thefirst 12 months of NYMEX gas futurescontracts) 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 isabout $4.25/MMBtu, the 24-and 36-month strips are not significantly higherat $4.65 and $4.85/MMBtu, respectively.Many gas producers believe the most dif-ficult question facing their businesses iswhether the fundamentals will push naturalgas prices higher in the near future. How-ever, we would argue that the ability tomanage risk tolerance and meet or exceedcash flow requirements, etc., should dictatehedging decisions, and not the manage-ment team’s opinion about future NYMEXprices.Once a producer decides to develop a

hedging program, one of the main issuesis identifying the best types of hedginginstruments that will allow the companyto meet its business objectives. The firststep is determining the organization’s tol-erance for risk as well as its hedginggoals and objectives. What is the companyseeking to accomplish by hedging? Is itto smooth volatile cash flows? Guaranteea minimum revenue stream? How muchupside is the company willing to give upin order to reduce or eliminate exposureto low prices?Only after answering these, as well as

many related questions, should a producerbegin to determine what hedging instru-ments it should consider employing inany given market environment.As it relates to hedging and risk man-

agement, there are a number of commonmistakes that oil and gas companies needto avoid at all costs. First, it is crucial toremember that hedging should not beconsidered a source of income. A welldesigned hedging strategy should providecash flow and revenue certainty, the abilityto lock in profit margins and/or protectionagainst declining prices. If a producingcompany initiates a hedging program inorder to generate profits, it has become aspeculator. While there are a few excep-tions (such as trading around storage ortransportation assets), speculating onprices is not a form of hedging.The vast majority of hedging mistakes

are the result of a poor or nonexistentrisk management policy, or the lack of asound hedging strategy. Most hedgingmistakes can be avoided if the companytakes the time and makes the effort tocreate a proper risk management policyand develop and implement strategiesthat allow it to meet its hedging goalsand objectives.

Some companies attempt to hedge onlywhen they “see good opportunities,” oronly when they have a strong opinionabout the market. The truth is, hedgingdecisions should not be made solely, oreven mostly, based on one’s view of futureprice movements. It is impossible to ac-curately predict commodity prices. Inkeeping, producers should not attempt to“selectively” hedge by hedging only whenthey think prices will fall and not hedgingwhen they believe prices will rise.Another dangerous approach is “all

or nothing” hedging, where a companyhedges either all of its production ornone of it based on its view of whetherprices will move up or down. In either ofthese approaches, guessing wrong on fu-ture price directions can have a disastrousimpact 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 difficultand risky undertaking, given all the vari-ables that come into play.The oil and gas industry always has

been a volatile and cyclical business, andthe future is likely going to continue topresent many hedging and risk manage-ment challenges to the industry. Producerswould be well served to create and im-plement proper hedging and risk man-agement policies, or review and reassesspolicies that are already in place, to makecertain they are mitigating their exposureto price risk (as well as credit, regulatory,operational and basis risk) in today’s un-certain economic environment. r

MICHAEL CORLEY is founder andpresident of Mercatus Energy AdvisorsLLC (formerly EnRisk Partners), aHouston-based energy trading andrisk management advisory firm. Priorto founding Mercatus Energy Advisors,he worked for several energy consultingfirms, where he served as an energytrading and risk management adviserto oil and gas producers, commercialand industrial energy consumers, andenergy marketers. Earlier in his career,Corley held various positions in trading,structuring, scheduling and quantitativeanalysis with El Paso Merchant Energyand Cantor Fitzgerald. He is a graduateof the University of Oklahoma.

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