Nucor praised for pursuing natural hedge

US steel maker’s acquisition of natural gas assets is seen as viable long-term hedge and an alternative to derivatives

Nucor hopes natural hedge will counter the heat of high gas prices

A recent deal between North Carolina-based steel maker Nucor and Calgary-based natural gas producer Encana might serve as a model for other companies seeking to hedge their energy exposure through acquisitions of physical assets, say market observers.

On November 6, Nucor revealed it was buying a 50% working interest in certain US natural gas wells operated by Encana. The steel maker said it expected to invest $3.64 billion in the gas assets over the lifetime of the agreement, which it estimated at 13 to 22 years.

In effect, the deal creates a natural hedge for Nucor, which is exposed to any future increase in natural gas prices. "By entering into this new agreement, Nucor will be better able to manage its exposure to natural gas volatility and overall energy demand for its manufacturing operations," the firm said in a statement.

Risk management experts were largely upbeat about the deal, which expands on a much smaller agreement between Nucor and Encana from 2010.

"It certainly could be a lot more cost-effective than trying to continuously hedge with financial instruments over a long period of time, [which] costs a lot of money," says Dominick Chirichella, president of the Energy Management Institute, a New York-based firm that advises companies on energy risk management.

It certainly could be a lot more cost-effective than trying to continuously hedge with financial instruments

Low natural gas prices – a consequence of the boom in North American shale gas production – could inspire other end-users to make similar deals, Chirichella believes. "It's certainly a good time to buy natural gas assets," he says. "The price is still pretty cheap."

The front-month benchmark Henry Hub futures contract traded on Chicago-based CME Group's Nymex exchange settled at $3.666 per million British thermal units (/MMBtu) on December 6, after sinking to 10-year lows of below $2/MMBtu earlier this year.

Nucor, which declined to comment for this article, is not the only US industrial firm that has taken notice of low gas prices and acquired physical assets as a natural hedge. On October 31, LSB Industries, a manufacturing and chemicals company based in Oklahoma City, said it had closed a $49 million deal to buy working interests in shale gas wells in Pennsylvania, describing the acquisition as protection against future natural gas price increases.

The emergence of shale gas has made such deals a more feasible alternative to hedging via derivatives, says Ruben Moreno, a Washington, DC-based assistant vice president with Concentric Energy Advisors, an energy risk consultancy. Past natural gas projects tended to be too large for such purposes, but the smaller, more piecemeal nature of shale gas projects makes it easier for an end-user to buy assets whose output matches its level of energy consumption, he explains.

"Compared to more traditional types of natural gas, it is easier to align a specific end-user load to a shale project," Moreno says.

A key factor behind Nucor's deal with Encana was the steel maker's plan to greatly increase its output of direct reduced iron (DRI), a form of iron that requires natural gas as a major input in the production process. Nucor is building a DRI plant in Louisiana, which is scheduled to start production in 2013, and has obtained permits for a second one. The volume of gas produced by the wells in Nucor's two deals with Encana is expected to equal Nucor's natural gas usage at all of its US steel mills, plus two DRI facilities.

Nucor and Encana structured their deal so the steel maker will be protected in the event that natural gas prices fall too low, making the wells unprofitable. In a November 6 filing with the US Securities and Exchange Commission (SEC), Nucor said the deal included a provision under which the two companies had agreed to a "pre-determined threshold" for natural gas prices. If the average price of gas falls below that level for 30 consecutive business days, either company can suspend drilling operations, according to the SEC filing.

Essentially, Nucor has purchased the equivalent of a call option to cover its natural gas needs for the duration of the agreement, Moreno says. He believes it would be unworkable for Nucor to fashion such a long-term hedge using financial instruments. "If you were trying to buy a call option for that time frame, it would be excessively expensive," Moreno says. "Open interest on calls beyond four years is extraordinarily thin, so they become too expensive to trade."

Nonetheless, some industry experts see potential dangers in the deal and similar efforts by end-users to hedge through the purchase of natural gas assets. They note the wells might produce less gas than expected, get shut-in, or run afoul of regulations. In other words, Nucor may simply be exchanging one set of risks for another.

"The number of things that could go wrong is nearly endless," says Mike Corley, president of Mercatus Energy Advisors, a Houston-based consultancy that advises companies on energy hedging. "Time will tell whether these are good decisions," he adds. "It is certainly a different approach than many have taken in the past."