Written by Michael Corley, Founder and President, EnRisk Partners
Since the NYMEX crude oil futures were introduced in 1983, exploration and production companies have had the ability to hedge their exposure to volatile oil and gas prices. However, for many companies, hedging and risk management can create as many challenges as they are intended to solve. In the past few years we have seen crude oil prices rise from $50 to $147 only to quickly decline back to $35 and then rising back to $75 as this article is being written. A similar history can be shown for natural gas, with NYMEX futures declining from a peak of $13 in the summer of 2008 to under $3 in the fall of 2009 and back to $6 this past winter.
In addition, we have witnessed a credit environment like none other in recent memory, which has created many additional challenges for E&P companies. As if price volatility and credit constraints aren’t challenging enough, the industry now faces potential regulatory challenges, disguised as financial reform, that will most likely create additional challenges as it relates to oil and gas hedging. As we all know, predicting future oil and gas prices is very difficult, if not impossible. No matter how sound your analysis it’s simply a very difficult undertaking as there are so many variables that come into play. So what’s an E&P company to do with respect to hedging? For starters, you need to begin by determining your tolerance for risk as well as your hedging goals and objectives. That is, what are you trying to accomplish by hedging? Smoothing out volatile cash flows? Guaranteeing a minimum revenue stream? How much upside price participation are you willing to “give up” in order mitigating your exposure to declining and/or low prices?
Only after you have answered these and many related questions should you begin to determine what hedging instruments, and the related tenor, you should consider employing in any given environment. Swaps, collars, put options and three-way options, among others, are all viable hedging instruments but without proper analysis and planning, an improper hedging program can create numerous challenges as well. In the current environment we can create a strong case for both $50/BBL and $100/BBL, the key to hedging success for E&P companies is implementing a hedging program that “works” in both high and low price environments.
While price risk is the…
