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Hedging Advice for Oil & Gas CFOs

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To Hedge or Not to Hedge: Hedging Advice for Oil & Gas CFOs. The Global Commodities Report. May 2011.

To Hedge or Not to Hedge: Hedging Advice for Oil & Gas CFOs. The Global Commodities Report. May 2011.

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  • 1. presentsto hedge or Notto hedge by Michael Corley
  • 2. 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
  • 3. by Michael corley Founder and President of Mercatus energy Advisors LLCA 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 companieschallenge exploration and production compa- across the globe, there are several key aspectsnies (e &Ps). of hedging that we tend to highlight because they are often overlooked or misunderstood:Historically, many have argued that e &Psserve as vehicles for obtaining exposure to 5 The structures of hedges are crucial. Thereenergy commodity prices. However, in recent are significant differences, such as basis, credityears, 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 – differencestheir 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 orand investors alike detest the idea of not be- indirect, can lead to a disaster if the structuresing 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 ane &P’s worst nightmares. 5 e &Ps must “stress test” their hedge portfo- lio so that the performance of both individualThe 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 includeprice 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 optionsand collars, among others. Issue 02 | 3
  • 4. 4 | Issue 02 95 – 115 – 135 – 155 – 35 – 55 – 75 – Apr. 2007 – $/ BBL Swap Jun. 2007 – Aug. 2007 – Oct. 2007 – Swap 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 Collar Oct. 2009 – Costless 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 – –2 –4 –6 –8 – 14 – 16 – 12 – 10 Put Option Put $/ MMbtu Option Market Price
  • 5. 5 Companies should not solely depend on their that hedging should not be considered a sourcebanks or trading counterparts to provide hedg- of revenue. A well-designed hedging strategying 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/ortheir 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 hedgingalign with the best interests of the customer. program for profit, it has become a speculator.simply accepting the exact hedging structuresuggested by the bank or trading company is The vast majority of hedging mistakes are therarely 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 managementWhen an e &P decides to develop a hedging policies, or review and reassess policies thatprogram, one of the main challenges is iden- are already in place, to make certain they aretifying the best types of hedging instruments mitigating their exposure to energy price riskthat will allow the company to meet its busi- (as well as credit, regulatory, operational andness objectives. basis risk) in today’s uncertain economic en- vironment. $The first step is determining the company’srisk tolerance as well as its hedging goals and Michael Corley is veteran energy trader andobjectives. specifically, what is the company founder and president of Mercatus Energyseeking to accomplish by implementing hedg- Advisors LLC (formerly EnRisk Partners), aing 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 heldHow much upside is the company willing to various roles in energy trading, marketing andgive 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 consultingthese questions, as well as many related ques- firms. • 713.970.1003 • MercatusEnergy.comtions, should an e &P discuss what hedginginstruments to use.pItfAllsIn addition, there are a number of common,hedging mistakes that e &Ps need to avoidat all costs. First, it is crucial to remember Issue 02 | 5
  • 6. Issue 02 | May 2011 excerpt from The Global Commodities Report Issue 02 | May 2011 Published by New Vanguard Media Inc. Coal www.the-Gcr.com Ancient Fuel, New Opportunities +12 Other Features » A Trio of Top TSX Junior Miners • Energy Hedging Tips for CFOsAg Minister Interview • Mexico & Montana Momentum • New Analyst Investor Scorecard

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