Oil & Gas Hedging Strategies for E&P companies in 2010 and Beyond

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 “energy risk” (the others being credit, basis, operational and regulatory) that receives the most attention in the E&P business, credit risk cannot be ignored, especially in the current environment. While credit risk is traditionally viewed, as it relates to hedging, as the risk related to a counterparty’s ability to perform, which is most definitely a risk that demands constant and consistent due diligence, there is also another aspect of credit risk that has become prevalent in the current environment. As an example, in recent months we’ve received numerous inquiries from O&G producers that are being forced to find new hedging counter-parties as their current/former counter-party(s) are no longer able to provide them the ability to hedge, most often due to credit related issues. The reasons are many, but among others, here are a few that we are witnessing first hand:

• E&Ps’ credit facilities being reduced, which in turn reduces their credit available for hedging
• Banks energy companies reducing / eliminating their trading businesses
• Counterparties, both banks and energy companies, reassessing their risk tolerance which has forced many counterparties to severe relationships with their all but their best/largest customers

So what should E&P companies be doing in order to avoid these potential scenarios? Number one, it’s ideal to have at least several potential counterparties. In addition to traditional lenders that offer hedging, there are many energy companies, ranging from boutique trading firms to major oil companies, which provide E&P companies the ability to hedge their exposure to oil and gas prices. Having said that, the process of establishing a relationship with an additional counterparty(s) can take weeks, if not months, so it’s best to begin the process well before you anticipate needing or wanting to execute a trade. On this note, if you need assistance locating potential counterparties please give us a call, we would be glad to make the proper introductions. In addition to price and credit risk, E&P companies may very well be subjected to hedging related regulatory risk in the months and years to come.

As has been well publicized in the media, the “financial reform” package being proposed in the United States seeks to move the majority of over- the-counter trading onto exchanges, limits the ability of “banks” to trade to trade OTC swaps and options, etc. While there are many flaws related to trading in the proposed legislation, the current version does include exemptions for “end-users”, which we believe would include most energy companies, including E&P companies. What is not clear is whether a trade between an E&P company and a bank would have to be cleared via an exchange or approved clearing organization. While we are optimistic that the end- user exemption will allow E&P companies, as well as all end-users, to hedge in the OTC markets as they do today, it’s simply too early to say whether this will actually be the case if/when the legislation is passed.

Which begs the next question, if the majority of energy trading in the US moves to a cleared trading environment, will the other major energy trading hubs (London, Singapore and Calgary) follow suit with similar legislation and regulations? Again, it’s too early to tell, especially given the current political environment across the globe. In summary, the coming months and years are going to present many hedging and risk management challenges to the E&P industry. All companies will be well served to create and implement a proper hedging and risk management policy (or to review and reassess your current policy(s) if you already have one in place) which not only addresses price, credit and regulatory risk but operational and basis risk as well.

Michael Corley is the Founder and President of EnRisk Partners, a Houston based energy trading and risk management advisory firm. Prior to founding EnRisk Partners, Mr. Corley worked for several energy consulting firms where he served as an energy trading and risk management advisor to oil & gas producers, commercial and industrial energy consumers and energy marketers. Earlier in his career, Mr. Corley was an independent energy trader and a natural gas options broker at Cantor Fitzgerald. While at Cantor Fitzgerald he also served as a risk management consultant to a natural gas utility company. Mr. Corley began his career at El Paso Merchant Energy where he held various positions in trading, structuring, scheduling and quantitative analysis; covering crude oil, electricity, natural gas, natural gas liquids and refined products. As a subject matter expert, Mr. Corley regularly advises commercial banks, hedge funds, private equity firms and professional services firms on various aspects of energy trading and risk management. Mr. Corley is a graduate of The University of Oklahoma. Mr. Corley can be reached at +1 713 844 6384 or via the firm’s website: www.enriskpartners.com