presents

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 evolve, the question of whether to hedge, or not to hedge, continues to challenge exploration and production companies (e &Ps). Historically, many have argued that e &Ps serve as vehicles for obtaining exposure to energy commodity prices. However, in recent years, industry best practices have evolved and the new consensus is that e &Ps must take their own proactive steps to mitigate risk, including commodity price risk. Theres no question that management teams and investors alike detest the idea of not being able to reap the benefits of high energy prices. And rightfully so. On the other hand, low and/or volatile prices can be one of an e &Ps worst nightmares. The key to a successful hedging program is developing and implementing strategies that perform as intended in both high- and lowprice environments, as well as in between. That typically means utilizing a combination of instruments, including swaps, put options and collars, among others.

OverlOOked Aspects In our firms daily discussions with companies across the globe, there are several key aspects of hedging that we tend to highlight because they are often overlooked or misunderstood:

5 The structures of hedges are crucial. There

are significant differences, such as basis, credit and operational exposure, in the various hedging structures available to e &Ps differences often overlooked by companies. so-called exotic hedges, most of which involve the selling of options, either direct or indirect, can lead to a disaster if the structures are not completely understood by the management team.

5 e &Ps must stress test their hedge portfo-

lio so that the performance of both individual hedge positions, as well as the entire portfolio, are well understood in all potential price environments. These tests should not only include price (market) risk, but basis, credit and operational risk as well.

Issue 02 | 3

4 | Issue 02

155

135

115

95

75

$/ BBL

55

35

Swap

Market Price

Swap

HedGInG exAMples

OIl & GAs vOlAtIlItY: NYMeX Crude Oil Natural Gas

Costless Collar

Costless Collar
Market Price

Data: Mercatus Energy Advisors

Apr. 2007 Jun. 2007 Aug. 2007 Oct. 2007 Dec. 2007 Feb. 2008 Apr. 2008 Jun. 2008 Aug. 2008 Oct. 2008 Dec. 2008 Feb. 2009 Apr. 2009 Jun. 2009 Aug. 2009 Oct. 2009 Dec. 2009 Feb. 2010 Apr. 2010 Jun. 2010 Aug. 2010 Oct. 2010 Dec. 2010 Feb. 2011 Apr. 2011

Put Option

$/ MMbtu

Market Price

14

16

12

10

Put Option

5 Companies should not solely depend on their

banks or trading counterparts to provide hedging strategies that are an ideal fit. Banks and trading companies take the opposite side of their customers hedges, which means the bank or trading companys best interest may not align with the best interests of the customer. simply accepting the exact hedging structure suggested by the bank or trading company is rarely in the companys best interest.

that hedging should not be considered a source of revenue. A well-designed hedging strategy should provide cash flow and revenue certainty, the ability to lock in profit margins and/or protect against declining prices, not to generate profits. If an e &P initiates a hedging program for profit, it has become a speculator. The vast majority of hedging mistakes are the 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 policy and to develop and implement strategies that allow it to meet its hedging goals and objectives. e &Ps will be well served to create and implement sound hedging and risk management policies, or review and reassess policies that are already in place, to make certain they are mitigating their exposure to energy price risk (as well as credit, regulatory, operational and basis risk) in todays uncertain economic environment. $ Michael Corley is veteran energy trader and founder and president of Mercatus Energy Advisors LLC (formerly EnRisk Partners), a Houston-based energy trading and risk management firm. Prior to founding the firm, he held various roles in energy trading, marketing and risk management with El Paso Merchant Energy, Cantor Fitzgerald, and several energy consulting firms. 713.970.1003 MercatusEnergy.com

It Is crucIal that hedgIng not be consIdered a source of revenue.

When an e &P decides to develop a hedging program, one of the main challenges is identifying the best types of hedging instruments that will allow the company to meet its business objectives. The first step is determining the companys risk tolerance as well as its hedging goals and objectives. specifically, what is the company seeking to accomplish by implementing hedging program? Is it to reduce cash flow volatility? To guarantee a minimum revenue stream? How much upside is the company willing to give up to reduce or eliminate exposure to low prices and/or volatility? Only after answering these questions, as well as many related questions, should an e &P discuss what hedging instruments to use. pItfAlls 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.
Coal
Ancient Fuel, New Opportunities

www.the-Gcr.com

+12 Other Features A Trio of Top TSX Junior Miners Energy Hedging Tips for CFOs Ag Minister Interview Mexico & Montana Momentum New Analyst Investor Scorecard