A disciplined approach

E&P companies tend not to strategically hedge in a rising market. But there are good reasons for them to do so, and some are sticking to their hedging strategies, despite suffering losses on their derivatives contracts. By Joe Marsh

Pure oil and natural gas producers often do not hedge energy prices – other than one-off hedges on specific acquisitions – in a bull market. They and their investors want to take advantage of any price upside. But some companies that actively hedge – such as Houston companies Petrohawk Energy and Plains Exploration – have stuck to consistent strategies, despite the hedging losses they have suffered in recent months.

Petrohawk’s strategy is to consistently hedge some 50%–70% of its oil and gas production up to two years out to maintain a more predictable revenue stream, whatever losses it suffers on those trading contracts, says Larry Helm, the company’s chief administrative officer.

Hence Petrohawk’s approach to Mission Resources Corp, an E&P company it acquired in July. Before the merger closed, Petrohawk got Mission to increase its gas hedging coverage for 2006, and at the same time put on a few more collars of its own for 2006 to retain the 50%–70% production hedge.

The company is evaluating additional hedges to increase its 2007 percentage. As well as using costless collars, Petrohawk has looked at buying simple put options – the right to sell when the price drops to a certain level – because they are relatively cheap now, says Helm. Puts are cheap at present because the expectation in the market is that prices will rise rather than fall.

Petrohawk formed just 15 months ago, but has made four acquisitions for a total of $1 billion, says Helm, speculating that the relative youth of the company might be one reason for its active hedging approach.

Despite negative mark-to-market of around $34 million on its oil and gas hedges in the first half of 2005, Petrohawk is standing by its strategy. “Those non-cash losses haven’t shaken our policy – we can’t outguess the market,” says Helm. “Our aim is to keep our revenue predictable, underpin our drilling programme and hopefully create shareholder value. We’re not worried about day-to-day price moves.”

Houston-based Plains Exploration is another producer to have maintained a consistent hedging programme, albeit with some restructuring of its hedge positions as a result of rising prices. Rating agency Standard & Poor’s (S&P) examines Plains Exploration’s hedging strategy, along with that of three other E&P companies in a report it published in August, Peer Comparison: Hedging Strategies For Four Oil And Gas Companies.

“Plains’ hedging policy reflects the nature of its reserve base,” says the report. “The company hedges to offset higher regional lifting costs and to help mitigate the negative differential its produced crude oil receives relative to Nymex [West Texas Intermediate]. Locking in fixed prices allows the company to meet its cost requirements and reduce variability in returns.”

Plains has repeatedly restructured its hedge positions in recent years, most recently in March 2005, as a result of it falling well out-of-the-money as energy prices have risen, says the rating agency.

In September 2004, Plains Exploration eliminated most of its existing 2005 swap positions at an average fixed price of $24.25 and entered into collar positions for 2005 through 2008 at an average floor and ceiling price of $25 and $34.76. Nymex WTI prices at the time had exceeded $45 a barrel (/bbl), more than $20 higher than Plains’ fixed-price swap positions in 2005, justifying the move, says S&P.

Following Plains’ initial restructuring, prices continued to rise, and by March 2005 prices reached $55/bbl. So Plains then hedged 80% of oil production and an additional 13% of natural gas production in the first quarter and around 75% of oil production in the second through third quarters of the year. Like Petrohawk, Plains is making full use of puts in its current strategy, due to the “attractive pricing available” on such options, says the report.

Hedge-free

Despite the activity of Plains and Petrohawk, it is common for producers not to strategically hedge at all when prices are high and rising, says Thomas Bentz, senior energy analyst at BNP Paribas in New York. “We’re still not seeing a whole lot of hedging by producers, because in a bullish market they want to retain the upside,” he says. “But that’s the thing: how can you tell when a bull market will turn? True, some may have hedged at $50 and are now carrying those prices.”

A producer may well feel it is unwise to hedge in the current environment, adds Bentz, but the price could drop heavily at any time. One way to insure against that is to keep a “$5 trailing stop”, he says. So, if the Nymex WTI price is at $65/bbl, the company does not hedge, but if it drops to $60, the company locks in at that price for at least some of its production, in case the price drops further.

On the other hand, says Bentz, with Opec pumping at almost full capacity and global demand so high, it does make one wonder whether a company should lock in prices.

Indeed, the WTI crude price is showing little sign of easing, having hit $70/bbl for the first time ever in late August on the back of Hurricane Katrina. The UK’s Financial Times even published an article in August outlining a worst-case scenario – involving a combination of terrorist attacks, adverse weather conditions and so on – where the crude price might hit $120/bbl.

Mark Routt, oil analyst at Energy Security Analysis in Wakefield, Massachusetts, says some producers certainly question the wisdom of hedging in such a market. “If we are in a situation where demand is outstripping supply, why would you sell away your upside?” he says.

“Producers are naturally long crude oil so they will tend to hedge in a down market but not in an up market, except to cover an acquisition,” adds Routt. “And their investors may not want them to hedge, because those investors may want the upside.”

Credit considerations

The S&P hedging report backs up this view up to an extent. “Many oil and gas E&P companies do not hedge because it limits the appeal of commodity risk to the equity shareholders,” says the report. “Many investors view E&P equity as a proxy for oil and gas commodity prices.”

Moreover, says S&P, hedging may also have unfavourable considerations from a credit standpoint, such as:

• costly restructuring of out-of-the-money contracts in a high-price cycle;

• margin posting requirements that may constrain liquidity; and

• the short-lived nature of hedge contracts, which provides limited support to a company’s financial profile.

As a result, says the report, S&P does not necessarily give a company credit for mitigating price risk.

Yet S&P also highlights the importance of hedging in “providing certainty of cashflows for associated debt issuance”. Andrew Watt, a credit analyst at S&P, says that if an E&P company has a significant level of debt, it will tend to do some level of hedging, to give comfort to the banks who are providing the financial backing. Meanwhile, most producers hedge specific acquisitions, particularly among the smaller and mid-sized companies, says Watt.

In the end, each producer will take the approach that suits its management team and its financial profile – whether that means hedging strategically or not.

For those that do hedge, consistency seems to be the watchword. “Hedging is one of those things you will be wrong on, no matter what you do,” says Petrohawk’s Helm. “So you have to understand what your reason is for hedging and stick to it.”