Natural gas prices have fallen to their lowest level in three years. After peaking above $13 per thousand cubic feet in June 2008, prices have fallen to less than a third of that value, despite a record cold December 2009, and the hottest summer in 60 years in 2010.

One reason prices have remained low is that gas production is increasing. Observers estimate U.S. supply rose by 2.1 billion cubic feet a day in 2010 and will increase by 1.3 Bcf a day more in 2011. This would take wellhead production to an all-time high of 66 Bcf a day.

But that isn't all producers have to worry about.

Increased drilling in natural gas liquids-rich plays could further alter the supply landscape. Ethane production rose 18% in 2010, but demand has not kept pace. Should ethane prices sink low enough, processors will reject ethane, leaving it in the gas stream. This rich gas would simply be blended with third-party dry gas to meet pipeline specifications, and effectively increase gas supply. There have been periods when ethane rejection was credited with expanding gas supply by as much as 2 Bcf a day.

A review of recently disclosed details about a large independent's hedge program illustrates how some companies are seeking a solution to this dilemma by deviating from traditional hedge strategies.

Which Hedge Strategies?

Now that gas prices are low, banks have rolled out a menu of unusual hedge offerings that appear to help producers. Many of the strategies are referred to as "exotics," because they bundle several hedge instruments together to create unusual price and payout profiles. As we look at these financial products, we are reminded of the person who asked how much something cost, only to be told that if you have to ask, then you can't afford it. In the case of these more complex hedging structures, if senior management has to ask how this hedge will work, it probably is not appropriate for their business. We'll review some of these strategies.

A "hedge strategy" recently revealed by one independent in an SEC filing and publicly disclosed presentations was the writing of long-dated calls on natural gas through the year 2020. The calls had an average strike price of $8.08 per million Btu.

The producer sold rights to others that will allow their counterparties to buy gas at $8.08 whenever they elect to exercise the calls. In short, the producer has given away a lot of upside potential on future production in exchange for a relatively small premium received today. The strategy can't be called a hedge, because the cash it generated provides little protection from falling prices.

Long-dated cap sales. This involves selling calls for a set number of years in the future and is an aggressive way to finance current operations. The problem with this method is that it robs Peter to pay Paul. In practice, it significantly reduces a company's ability to hedge those volumes, because the premium received, which could be used to purchase floors, is unlikely to be available at a future date. Likewise, the company cannot sell swaps to lock in gas prices because those volumes have already been committed.

And what if prices rise in the near future, and rig costs rise to levels where budgets are constrained? How will the company be able to manage its budget when 2016 arrives and $8 gas is now unacceptably low for funding capex?

Extendables. This strategy has a similar shortcoming. Like long-dated caps, the strategy gives up rights on future production. The producer is given "a bump-up" on the swap, improving the hedge price, in exchange for awarding the counterparty an option or series of options in future years to buy its gas at the same level. Because the higher hedge price improves cash flow, several master limited partnership (MLP) producers have been drawn to this strategy. It helps them make distributions when prices are low.

However, there's no such thing as a free lunch. Since the extendable is not an obligation, the hedging company may find itself hamstrung if low prices persist. Rights granted by the producer are not hedges, but prevent the company from hedging its production, except with the purchase of puts.

Knockout options. These are "exotic" options. They offer help on the front end in exchange for giving a counterparty the right to void the deal if the price falls below or rises above a specific level. An independent energy producer lost important hedge protection a few years ago because of a knockout option. It purchased $9.64 gas puts and structured them so that they either got a higher floor price or lower premium price in return for the counterparty being able to void ("knockout") the deal if prices went below about $6.28.

The problem with this strategy? Just when the hedges were needed most (when prices were significantly lower), they were lost.

The last time gas prices settled above $6.28 was the December 2008 futures contract. There have been two years of consecutive settlements below $6.28. The hedge protection was worth more than $2 billion at the time it was lost.

Indeed, if we include the downside protection forfeited below $6.28 as settlements fell to $4 and lower (2009 settlements averaged $3.99, and 2010 settlements averaged $4.39), the amount of protection that this firm lost was worth somewhere between $3- and $4 billion.

Are strategies that lose hedges when they are most needed, or place obligations on volumes without providing price protection, really a hedge? We argue that they are not.

Simply, hedges should provide sufficient protection at an acceptable price. Given the variety of challenges that are faced by E&P companies, a hedge program should establish a balance between four important criteria: the risk profile of the firm's assets (portfolio dynamics); the firm's risk tolerance; its credit capacity; and the opportunities available in the market. When all four items are fully addressed, a hedge program will be appropriate and effective.

If hedges that include exotic options are to be avoided, which strategies should be considered? We believe that 99% of the time, businesses can use fixed swaps, floors, or a combination of floor purchases and cap sales (also known as a producer collar, reversed for a consumer) to achieve budgetary certainty. These "vanilla" options are the quiet mainstay of successful hedge programs.

What simple option strategies lack in exotic bells and whistles, they make up for with precise functionality. These strategies will not make headlines, but they are the building blocks of a hedge program that controls risk; can be explained to the board of directors; avoid paying counterparties excessive and unnecessary fees; are transparent and easy to value; and maintain focus on the company's core business.

Hedging Now

The first question to ask is, "Where might prices go?" It is useful to consider where natural gas prices have been. While the fundamentals of the industry are ever-changing, many of the forces at work in determining price are just as relevant in today's marketplace as they were a few years ago. Producers can use this historical information and the expectation that gas supplies are likely to be ample to review the hedging opportunities at hand.

For almost two years, gas prices have been in the trading range of $4 to $6 per million Btu. On the demand side of the equation, fuel-switching and growing storage capacity are supporting prices near $4. On the supply side, liquefied natural gas (LNG) acts as a cap on prices, because significant supplies have been redirected to the U.S. during price spikes to $6.

This coming year, mild weather (i.e. no hurricane shut-ins, less winter demand, etc.) could push the range down toward $3.50 to $5.50 per million Btu. By way of example, just the threat of storage congestion knocked down September 2009 swaps to a settlement price of $2.84. Now that storage capacity has increased, prices that low are not expected unless we have both winter and summer busts, along with no producer shut-ins. But that doesn't mean it can't happen.

A producer who needs to hedge must also answer the following question: At what price will its operations be affected negatively? If the required price is $4, then acquiring costless collars with $4 floors will provide protection sufficient to withstand any price downturn. Pricing for natural gas is in contango, which lifts swap prices in the forward years. The calendar-year 2013 swap was a dollar higher than the 2011 swap in October 2010 (see "Producer Hedge Pricing" below).

The hedging producer also benefits from the assumption that prices are log-normally distributed. In each case shown in the table, collars provide the producer with floors that are closer to the swap price than is the cap. This means that the producer can get protection at $4 in year 2012, only $1.20 away from the swap, while selling the cap at $7. This cap is $1.80 away or 1.5 times further from current prices.

Importantly, $7 is a reasonable price when compared to historical settlements (see "Historical Gas-Price Settlements"). Essentially, there were only two years in the past decade where events significantly caused the gas price to eclipse that amount (2005, after Hurricane Katrina; and 2008, after the Semgroup bankruptcy event).

Since January 2000, only 26% of the settlements exceeded a price of $7 (see "Number Of Months Settled At Shown Price Since 2000"). For 2012, hedging with collars, which give away the upside beyond that price, does not hold an extraordinary amount of risk.

On the contrary, if prices reach that $7 level, producer cash flows would increase dramatically, presenting the opportunity to lock in even better hedges. Collars can provide the needed downside protection ($4 floors), while maintaining upside participation to levels that are 34% above the 2012 swap price. These hedges protect when prices are low and allow other production periods to be hedged when it makes sense to do so.

It is also worth noting that spot prices are below $4 right now. That means that $7 caps are 75% above the current price! What other business will guarantee a minimum sales price equal to current prices and keep the upside for the next $3 at no out-of-pocket cost?

It isn't likely that natural gas prices will fall to $3 this winter. However, the possibility of sustained lower prices can never be ruled out. The gas industry might be hit with a perfect storm, which could involve ethane rejection, effectively increasing supply, and extremely mild weather, which would curtail demand. Our motto is: Manage for those things that you expect to happen, but have a plan for those things you don't.

Collars may not be fancy or exotic, but they are effective.

Another word of advice: an enterprise should not "trade" around its hedge program. Some counterparties and advisory firms advocate liquidating existing hedges when they become profitable. They then hope to replace those hedges at better levels.

Trading a hedge portfolio can be profitable, but it can also backfire if the decisions made do not get help from good market timing. Management teams may become distracted by price and lose their focus on the core competencies that drive the success of their businesses. In addition, repeated transactions accumulate fees to brokers and slippage to counterparties that must be overcome to achieve financial success. The active trading of a hedge portfolio is unlikely to be in a producer's best interest.

Wayne Penello is president and Andrew Furman is managing director of Risked Revenue Energy Associates, a risk-management and hedging-consulting firm in Houston. They can be reached at 713-522-6161.

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