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To Hedge Or Not To Hedge - That Is The Question

Posted: Feb 23, 2009 10:09 AM by Eric Fox

Tickers in this Article: SU, XTO, DPTR, CLR

The profitability of an exploration and production company is obviously highly dependent on the price of oil and gas, which tends to increase the volatility of revenues and earnings for the sector. The good news is that these companies can use financial instruments to hedge production and lock in a price of the commodity for several years out. This is a common strategy for companies in the sector although some choose to go without any protection.

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Common Practice
Many companies take advantage of this protection to at least partially hedge. A recent report from Shannon Nome, an analyst at Deutsche Bank said that of the 22 firms in her survey, the average amount of production hedged was 45% for 2009. Since oil and gas prices fell so precipitously the last six months, most of these hedges lock in much higher realized prices for production.

One large company that just released its hedge position for 2009 and 2010 is Suncor Energy (NYSE:SU). For 2009, the company has locked in a minimum floor price of $53.50 for 180,000 barrels per day of production. In 2010, the company has established a floor price of $50 and a ceiling of $68 for 50,000 barrels per day of production.

Monetize
Another strategy that a company can pursue with its hedge position is to monetize it, if it is in the money, and settle it for a cash payment, and reset the hedges. XTO Energy (NYSE:XTO) has done this twice so far in 2009. The first settlement yielded $900 million after tax and the second gave the company $800 million. The company said it would use the proceeds to pay down debt. XTO still has 30% of its original 2009 hedges intact. (Learn how investors use strategies to reduce the impact of negative events on investments, see A Beginner's Guide To Hedging.)

Naked
Some companies decide not to hedge. Continental Resources (NYSE:CLR) was 100% unhedged at the end of its third quarter. "Our strong balance sheet reduces the need in most circumstances to hedge our production," said Harold G. Hamm, the CEO.

Problems
The decision to hedge is not without risks. If a company locks in a price and then sees a sharp move up in commodity prices, then it will miss out on the higher price. I imagine there were many exploration and production companies in early 2008 who hedged production at $100 a barrel for oil, only to see the price move up to $147 over the summer. This is typically why a company will only hedge a portion of its production.

Another problem is counter party risk. In 2008, when Bear Stearns and Lehman Brothers were having liquidity problems in the financial markets, many investors became wary of whether the hedges that these firms sold would be honored in case of a bankruptcy. The solution to this is to diversify the hedges with many different counter parties.

Delta Petroleum (Nasdaq:DPTR) was unhedged at the end of the third quarter of 2008. During the conference call, the company cited counter party risk as the main reason it ended its hedges. Kevin Nanke, the CFO said "one of the concerns was for the unknowns related to everything that was going on with all of the banks and the markets, and having an unwillingness to try and determine whether or not there would be counter party risk once the hedges ultimately came into play."

The exploration and production industry is one of the few industries that can use financial instruments to lock in a price for its product. This is a common practice in the industry and reduces the volatility of earnings for the sector. However, some companies, for different reasons, choose to remain unhedged and take on the full force of the volatility of commodity prices.

Discover how to find and use the most cost-effective ways to transfer risk, read Practical And Affordable Hedging Strategies.

By Eric Fox

Eric J. Fox, is the founder of Brittain Capital Management, LLC., which manages the Alesia Fund, LP., a Value oriented long/short investment partnership. You can read more of his views on investments at his blog - Stock Market Prognosticator.

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