To Hedge or Not to Hedge: Oil & Gas Hedging for CFOs by mercatusenergy


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to hedge
 or Not
to hedge

  by Michael Corley
           to hedge
            or Not
           to hedge
               Hedging advice for oil & gas CFO s

          Oil & gas is a volatile and cyclical business and
          will always present both hedging opportunities
           and risk management challenges. The Global
            Commodities Report asked a veteran energy
           trader and risk manager for pointers on how
           to use hedging to mitigate risk and avoid the
                        pitfall of speculation.

2 | Issue 02
               by Michael corley

               Founder and President
               of Mercatus energy Advisors LLC

         s the energy markets continue to         OverlOOked Aspects
         evolve, the question of whether to
         hedge, or not to hedge, continues to     In our firm’s daily discussions with companies
challenge exploration and production compa-       across the globe, there are several key aspects
nies (e &Ps).                                     of hedging that we tend to highlight because
                                                  they are often overlooked or misunderstood:
Historically, many have argued that e &Ps
serve as vehicles for obtaining exposure to       5 The structures of hedges are crucial. There
energy commodity prices. However, in recent       are significant differences, such as basis, credit
years, industry best practices have evolved and   and operational exposure, in the various hedg-
the new consensus is that e &Ps must take         ing structures available to e &Ps – differences
their own proactive steps to mitigate risk, in-   often overlooked by companies.
cluding commodity price risk.
                                                  5  so-called exotic hedges, most of which in-
There’s no question that management teams         volve the selling of options, either direct or
and investors alike detest the idea of not be-    indirect, can lead to a disaster if the structures
ing able to reap the benefits of “high” energy    are not completely understood by the manage-
prices. And rightfully so. On the other hand,     ment team.
“low” and/or volatile prices can be one of an
e &P’s worst nightmares.                          5 e &Ps must “stress test” their hedge portfo-
                                                  lio so that the performance of both individual
The key to a successful hedging program is        hedge positions, as well as the entire portfolio,
developing and implementing strategies that       are well understood in all potential price envi-
perform as intended in both high- and low-        ronments. These tests should not only include
price environments, as well as in between.        price (market) risk, but basis, credit and op-
That typically means utilizing a combination      erational risk as well.
of instruments, including swaps, put options
and collars, among others.

                                                                                        Issue 02 | 3
4 | Issue 02
                                                                                     95 –
                                                                                                   115 –
                                                                                                              135 –
                                                                                                                       155 –

                                                          35 –
                                                                 55 –
                                                                         75 –
                                                Apr. 2007 –

                                                                                                                               $/ BBL

                                                 Jun. 2007 –
                                                Aug. 2007 –
                                                Oct. 2007 –

                                                                                                                                                                                        Market Price

                                                Dec. 2007 –
                                                Feb. 2008 –
                                                Apr. 2008 –
                                                 Jun. 2008 –
                                                Aug. 2008 –
                                                Oct. 2008 –
                                                Dec. 2008 –

                                                                                                                               Crude Oil
                                                Feb. 2009 –
                                                Apr. 2009 –
                                                 Jun. 2009 –
                                                Aug. 2009 –
                                                                                                                                                                                                       Costless Collar

                                                                                                                                                                                        Market Price


                                                Oct. 2009 –

                                                Dec. 2009 –
                                                Feb. 2010 –
                                                                                                                                                                                                                         HedGInG exAMples

                                                                                                                               Natural Gas
                                                 Apr. 2010 –
                                                 Jun. 2010 –
                                                Aug. 2010 –
                                                                                                                                             OIl & GAs vOlAtIlItY: NYMeX

                                                 Oct. 2010 –
                                                Dec. 2010 –
                                                Feb. 2011 –

               Data: Mercatus Energy Advisors
                                                 Apr. 2011 –

                                                                                                                – 14
                                                                                                                       – 16

                                                                                                       – 12

                                                                                            – 10
                                                                                                                                                                                                       Put Option


                                                                                                                               $/ MMbtu
                                                                                                                                                                                        Market Price
5 Companies should not solely depend on their     that hedging should not be considered a source
banks or trading counterparts to provide hedg-    of revenue. A well-designed hedging strategy
ing strategies that are an ideal fit. Banks and   should provide cash flow and revenue certain-
trading companies take the opposite side of       ty, the ability to lock in profit margins and/or
their customer’s hedges, which means the bank     protect against declining prices, not to gen-
or trading company’s best interest may not        erate profits. If an e &P initiates a hedging
align with the best interests of the customer.    program for profit, it has become a speculator.
simply accepting the exact hedging structure
suggested by the bank or trading company is       The vast majority of hedging mistakes are the
rarely in the company’s best interest.            result of a poor or nonexistent hedging policy
                                                  or failing to abide by the policy. Most hedging
                                                  mistakes can be avoided if the company takes
                                                  the time and effort to create a proper hedging
 “ It Is crucIal that                             policy and to develop and implement strate-
   hedgIng not be                                 gies that allow it to meet its hedging goals and
   consIdered a source                            objectives.
   of revenue.”
                                                  e &Ps will be well served to create and imple-
                                                  ment sound hedging and risk management
When an e &P decides to develop a hedging         policies, or review and reassess policies that
program, one of the main challenges is iden-      are already in place, to make certain they are
tifying the best types of hedging instruments     mitigating their exposure to energy price risk
that will allow the company to meet its busi-     (as well as credit, regulatory, operational and
ness objectives.                                  basis risk) in today’s uncertain economic en-
                                                  vironment. $
The first step is determining the company’s
risk tolerance as well as its hedging goals and   Michael Corley is veteran energy trader and
objectives. specifically, what is the company     founder and president of Mercatus Energy
seeking to accomplish by implementing hedg-       Advisors LLC (formerly EnRisk Partners), a
ing program? Is it to reduce cash flow volatil-   Houston-based energy trading and risk man-
ity? To guarantee a minimum revenue stream?       agement firm. Prior to founding the firm, he held
How much upside is the company willing to         various roles in energy trading, marketing and
give up to reduce or eliminate exposure to low    risk management with El Paso Merchant Energy,
prices and/or volatility? Only after answering    Cantor Fitzgerald, and several energy consulting
these questions, as well as many related ques-    firms. • 713.970.1003 •
tions, should an e &P discuss what hedging
instruments to use.


In addition, there are a number of common,
hedging mistakes that e &Ps need to avoid
at all costs. First, it is crucial to remember

                                                                                       Issue 02 | 5
                                                                  Issue 02 | May 2011

                                                                                        excerpt from
                                                                                        The Global Commodities Report
                                                                                        Issue 02 | May 2011

                                                                                        Published by
                                                                                        New Vanguard Media Inc.
                                         Ancient Fuel,
                                         New Opportunities

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