?Higher prices for natural gas during the past four years have obviously been a welcome boon to the E&P sector. But these new conditions have caused many E&P companies to take another look at their hedging practices. Previously, the gas market traded in a somewhat narrow band, with some price spikes but overall lower volatility, so there was less perceived need for price-risk management. The higher price environment has spurred a surge of gas-production growth not only through the drill bit but also through acquisitions, and of course, increasing development costs have accompanied this trend.


Over the past four years, the industry has seen an apparent increase in price volatility, which has brought the concept of hedging to the forefront for producers and their lenders.


Since 2004 gas prices have vacillated dramatically, rising from $4.52 to $15.78 in 2005 and then falling back to $4.05 in 2006. The most recent run-up took from December 2007 to July 2008 for prices to rise from $7.17 to the latest high of $13.69; however, it took just 42 trading days for gas to erase those gains—a stunning 95% reversal in a very short period of time. It should come as no surprise there has been a dramatic increase in hedging activity, and in response, the financial markets have become much more liquid and transparent.


Producers hedge for various reasons: to lock in future cash flow on existing production, to lock in anticipated cash flow on production associated with acquisitions, to increase the borrowing base within their banking facilities or lending syndicates, and ultimately to reduce the impact of price volatility on company profits.


Tactics vary. Some producers seek to lock in a high percentage of their PDP (proved, developed producing reserves) within the next two years as a conservative play to assure value for their shareholders. Others hedge only what their banking group mandates in order to assure the funding needed for their current drilling programs. Producers even differ in how they implement hedges, with some taking a systematic approach in hedging each quarter, while others try to time the market and lay on many hedges opportunistically.

Themes emerge
Even though there are differing opinions about why, how and when companies should hedge, a few themes have emerged. Most every producer has some portion of its production hedged. Most every producer has used fixed-price swaps and/or costless collars to hedge that production. And finally, most every producer has taken a passive approach to its hedging programs by implementing derivative structures—and enduring the good and the bad results throughout the life of the hedge—in order to obtain that fixed price point or price range.
We find that many producers tend to implement a “static hedge” strategy, i.e., they put their hedges on and rarely revisit them throughout term.


There is no question that the producer’s market view at the time the hedge was implemented certainly justified the hedge price level; however, the markets are fluid and volatile, so taking a static approach to hedging in a dynamic environment can actually work against the producer.


Companies in this sector manage every aspect of their business, down to the specifics of each well, in order to capture optimal outcome. The hedge portfolios that most producers carry can have very significant notional values and resulting financial impacts on the company’s bottom line. It only makes sense that these hedges should be continually managed in such a volatile market so that producers can participate when commodity prices are higher, while assuring they are protected in downturns.


Asset Risk Management LLC (ARM) helps producers develop, implement and continually optimize their hedging portfolio, in order to allow for upside participation and increasing price protection to the downside. The company was started in 2004 at the time the industr­y saw the implosion of the merchant energy companies, which introduced a tremendous amount of volatility into the market. As well, that year marked the beginning of the commodity bull market.

Managed portfolios
There is a contrast between how companies typically hedge their commodity exposures and the value delivered by actively managing the hedge portfolio. Results of the managed portfolios have been impressive in comparison to those passively managed, as exemplified at the top of the commodity market in late June 2008.


One producer client reported that as a result of ARM managing its hedge strategy from April 2008 to the time this article was written, it gained a net 37% increase in its gas price above what would have been realized under its original (passive) hedging plan. Many steps were taken over time in order to respond frequently to the changing dynamics of the market. As a result, this producer moved its original floor from $7 to $9 while also removing its original price cap of $10.50; thus allowing this company to benefit as gas prices climbed to about $13.50. (See chart.)


Those producers that had hedged on their own, without taking such optimization steps, typically received little to no upside participation as oil and gas prices surged upward. As the market turned over in early July, many producers were receiving, or rather enduring, all of the downside participation of the falling market. In addition, the negative position of their portfolios detracted from their ability to maximize their banking facilities.


Those who were participating in a managed hedge program got most, if not all, of the upside as the market climbed higher—while also increasing their floor price along the way. They were hedged against what we now know was a very dramatic price drop and did not participate in the majority of the downside.


Although it sounds easy to do, it takes quite a bit of expertise to manage these portfolios.


In this example, this particular producer sought to hedge its natural gas exposure through 2009. ARM identified certain aspects of the company that would affect what type of hedge structure would be best to achieve the company’s goals and provide maximum flexibility to optimize both the existing portfolio of hedges, as well as new gas volumes. ARM typically looks at the risk appetite of the company, what the debt load is, what the existing hedge portfolio looks like, and where the client truly starts experiencing pain from decreasing prices.?
In addition, ARM looked at the current market dynamics to see what value could be extracted. As the market began to climb in the beginning of the year, ARM took a view based on the market fundamentals and technical influences and advised its client accordingly, without ever compromising the original levels of price protection. ARM began to open the upside for the producer in order to provide full participation, and continued to extract the value opportunities presented by the vacillating market, in order to optimize the floor price of its portfolio higher, thus limiting participation to the downside.


The end result throughout the commodity price run-up was a significantly higher increase in the client’s weighted average floor price, with no ceiling to limit the upside participation. ARM and the producer managed this portfolio throughout the year during an up-trending market, extracted real dollars as the opportunities were presented and brought those dollars back to the producer. This was achieved without compromising the protection of the original hedge.


A managed hedge portfolio will outperform a passively hedged portfolio every time. The price volatility of today’s energy markets—while beneficial to the trading desks—is a producer’s worst enemy.


This industry has gone beyond the era of companies simply locking in a price and hoping for the best. A static approach to hedging in a dynamic market is at best a 50/50 chance. An actively managed portfolio can increase those odds in order to ensure a company captures the maximum amount of value for shareholders.

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