E&P firms typically hold hedge positions to settlement. Few firms have a hedge policy that would allow them to do otherwise. In fact, Financial Accounting Standards Board (FASB) reporting requirements deter adjustments to hedge portfolios. However, producers do make adjustments. Occasionally, a publicly traded firm will report liquidating a hedge and, perhaps, replacing it. For example, Houston-based Mission Resources, which was recently acquired by Petrohawk Energy, modified its hedge portfolio in April 2005, canceling several existing oil collars and acquiring new swaps and collars at a cost of some $3.3 million. Earlier this year, volatile natural gas prices created an attractive opportunity for E&P companies to consider modifying their hedge portfolios. This article examines the criteria under which revising the hedge portfolio will improve its expected value. Following last winter's record $6.88-per-million-Btu average settlement, natural gas started out the 2005 summer season with the Nymex April 2005 contract closing at a record: $7.32. This lifted the balance of the summer swaps to new highs. Then, during the next two months, prices softened. On May 27th, the June natural gas contract on Nymex settled at $6.20, 15% lower than April. This downward pressure also pulled what remained of the summer swap lower. The price of the July-October swap fell almost 20%, from the $7.90 high it achieved in March to the $6.40 observed in late May. At this time, a market-neutral assessment of price potential for the July-October swap was made. It suggested that the balance of the summer had a 68% chance of averaging between $5.75 and $7.10 and a 95% chance of between $5.20 and $7.90. Here, hedges held by three E&P companies that covered the July-October period are reviewed, along with the estimated cost/benefit of adjusting them. Company A Company A held $6 puts that were purchased in the fall of 2004, long before the summer swaps challenged $8 in March 2005. Changes in market fundamentals and pricing now suggested that these puts were no longer very useful. The dilemma facing company A was that it wanted protection, but believed this hedge to be ineffective because the market would have to fall $0.40 (from the then-current price of $6.40) before these puts would provide protection. More importantly, the puts were trading for $0.20. This meant that, unless the remaining four months of summer averaged lower than $5.80, these puts were worth more today than they would be on settlement. To illustrate, if the average settlement price for July-October was $5.85 and the firm held onto the puts, it would receive $6 for the hedged production when it exercised its right to sell at $6. On the other hand, if the firm sold these puts for $0.20, it would not be protected and would receive the settlement price of $5.85. However, the $0.20 from the sale of the puts would be added to the $5.85 received, netting $6.05 to Company A. At any price above $5.80, collecting the $0.20 premium would be an attractive addition to revenues. Of course, if the settlement was any price below $5.80 the puts would provide superior protection. The company was much more bullish on price than $5.80 and recognized that there was little chance (about one in six) that prices would average below that level. They considered selling the $6 puts for $0.20 per million Btu. It may seem that it is not worth the effort to adjust a hedge portfolio for $0.20, since it would leave the company unhedged and require that it report this adjustment to shareholders. However, the sale of these puts would allow the company to implement replacement strategies that would raise its floors and more closely match its neutral view of the market. The company considered the following four strategies. Option No. 1. Do nothing, thus keeping the $6 puts. If the firm was very bullish, it would give this serious consideration because it would be hedged (however meaninglessly) and retain 100% of upside. Option No. 2. Sell the puts for $0.20 and simultaneously hedge with a swap at $6.40. This would raise the floor to $6.60 ($6.40 plus the $0.20 received from the put sale). Even a moderately bullish firm would not prefer this strategy because it forfeits all upside potential. The company would have been better off doing this earlier when the market was near its $7.90 peak. At that time, the $6 puts would likely be worthless, but the new hedge would have been executed at a historic high, resulting in revenues that could redefine budgetary targets. Option No. 3. Sell the puts and replace the hedge with a costless collar. This would allow the company to keep some upside and raise its floor price. For example, the company could have received a $6.15 floor and given away a $6.80 cap. This would have lifted the effective protection from $5.80 to $6.35 ($6.15 strike plus $0.20) at the cost of capping revenues at $7 ($6.80 strike plus $0.20). This cap was attractive because it was $0.60 above the then-current market and about $1 higher than the average settlement during the summer of 2004. Option No. 4. One strategy under review was not eligible for hedge accounting treatment because it net sold options. The company considered selling the puts and a $6.40 call to generate income. At the time, the calls were worth $0.50. This strategy was attractive because it out-performed all others through the most likely range of prices. The company would be capped at an effective price of $7.10 ($6.40 plus $0.20 plus $0.50). More importantly, the premiums received would be applied to revenues at all price levels, even if prices fell. One concern was the scenario in which prices averaged less than $5.30. At that price the company would be worse off. Company A did not perceive this as a material threat since there was about one chance in 50 that prices could drop that much. This raised the expected value of the hedged production 6%. Since the company was neutral to slightly bullish on price, it concluded that that this strategy, the short call, was the best. Before implementing the new strategy, it was given one final review. What would happen if the market exceeds the anticipated range? If this strategy incurred opportunity cost because the market rallied above $7.10, the outcome would be acceptable because revenues would be at least 11% higher than current expectations. On the other hand, the company was taking some risk that prices could fall below $5.30, the breakeven point relative to the "do nothing" strategy. However, management knew that, even in this extremely weak (and unlikely) price environment, the position would outperform the market by the $0.70 in premiums collected. Two other companies considered modifying their hedge positions at the same time. Their positions included swaps and deep in-the-money puts. Company B In December 2004, Company B sold a $6.60 swap for summer natural gas as high storage levels began to press prices lower. Changes in the fundamental picture led to record high prices in March. The price drop in May offered the company a chance to cover its swaps at $6.40 and collect a $0.20 profit. This firm wanted to remain hedged and considered replacing the swap with a $6.15/$6.80 costless collar, which would provide it with some upside. In addition, this would have increased the expected value of the hedge by between $0.02 and $0.06. While the modified structure was tempting, the potential for revenues to increase by $0.40 ($6.80 cap plus $0.20 gain) was not attractive enough, given that the company had to accept an additional $0.25 ($6.60 swap versus a $6.15 floor plus $0.20 gain) price exposure. Company B had a neutral market view and chose not to make the modification to its portfolio. Company C This firm held $7 puts that were part of a $7.00/$8.40 costless collar purchased when the market was near its high. Despite falling prices, this firm became more bullish with time and in May believed these puts had captured most of the value the company could hope to receive. Selling the puts for $0.75 would increase the expected value of the hedge by between $0.10 and $0.12. Company C decided that, while it wanted to be hedged at $7, it didn't need to be hedged at $6.40. It was confident prices were more likely to go higher than lower. They chose to sell these puts, put the premium in the bank and leave the short calls in place. Some might consider this unwise and it is clearly not eligible for hedge accounting treatment, but the company was locking in $0.75 that it would keep under all circumstances. In the final review process, if the short calls were exercised, the company would receive $9.15 ($8.40 plus $0.75) for summer gas. If prices fell, it would get $0.75 more than the market. In the unlikely event that prices fell to $5.30, it would still receive $6.05, incurring just $0.35 of opportunity cost when compared with current market conditions. Company C sold the puts. Summary When considering the modification of a hedge portfolio, producers should first ask, "How will my company perform through a range of expected prices?" Then ask, "What happens if prices exceed this range?" Each of the hedge modifications reviewed above increased the expected value of the hedged production. Equally important, the three hedges considered for unwinding had positive mark-to-market valuations. Once modified, the positive value of the liquidated hedges would be taken to earnings. However, when hedges with a negative mark-to-market are modified, the firm will lock in losses. If existing hedges are not profitable, modification is generally not recommended. One must consider modifications carefully under these circumstances. An example is when an E&P firm repurchases swaps for a loss because it is convinced the market is going higher. This would lock in those losses, which is fine if prices rally. However, should prices fall, the firm is no longer hedged and is stuck with the realized loss. When a hedge portfolio is suffering under mark-to-market losses, the preferred strategy is to do nothing or add hedges that will improve the average price of the hedge portfolio. Modifying profitable hedges to increase the expected value of the hedge portfolio can make meaningful contributions to the bottom line and withstand the scrutiny of auditors. Liquidating these hedges locks in gains, and it returns the company to its original position of holding the risk it accepted the day it purchased the asset or assets. Now, with more cash in hand, hedge strategies can be designed and implemented that more closely match the company's risk tolerance and market view. Firms should look for these opportunities because they present an opportunity to improve performance. Wayne Penello is president of Risked Revenue Energy Associates, a Houston-based consulting firm. He is the founder of the Risked Revenue Hedge Program and can be reached at 713-807-1920.

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