To Hedge or Not to Hedge: Hedging Advice for Oil & Gas CFOs. The Global Commodities Report. May 2011.

1. presents
to hedge
or Not
to hedge
by Michael Corley

2. to hedge
or Not
to hedge
Hedging advice for oil & gas CFO s
Oil & gas is a volatile and cyclical business and
will always present both hedging opportunities
and risk management challenges. The Global
Commodities Report asked a veteran energy
trader and risk manager for pointers on how
to use hedging to mitigate risk and avoid the
pitfall of speculation.
2 | Issue 02

3. by Michael corley
Founder and President
of Mercatus energy Advisors LLC
A
s the energy markets continue to OverlOOked Aspects
evolve, the question of whether to
hedge, or not to hedge, continues to In our firm’s daily discussions with companies
challenge exploration and production compa- across the globe, there are several key aspects
nies (e &Ps). of hedging that we tend to highlight because
they are often overlooked or misunderstood:
Historically, many have argued that e &Ps
serve as vehicles for obtaining exposure to 5 The structures of hedges are crucial. There
energy commodity prices. However, in recent are significant differences, such as basis, credit
years, industry best practices have evolved and and operational exposure, in the various hedg-
the new consensus is that e &Ps must take ing structures available to e &Ps – differences
their own proactive steps to mitigate risk, in- often overlooked by companies.
cluding commodity price risk.
5 so-called exotic hedges, most of which in-
There’s no question that management teams volve the selling of options, either direct or
and investors alike detest the idea of not be- indirect, can lead to a disaster if the structures
ing able to reap the benefits of “high” energy are not completely understood by the manage-
prices. And rightfully so. On the other hand, ment team.
“low” and/or volatile prices can be one of an
e &P’s worst nightmares. 5 e &Ps must “stress test” their hedge portfo-
lio so that the performance of both individual
The key to a successful hedging program is hedge positions, as well as the entire portfolio,
developing and implementing strategies that are well understood in all potential price envi-
perform as intended in both high- and low- ronments. These tests should not only include
price environments, as well as in between. price (market) risk, but basis, credit and op-
That typically means utilizing a combination erational risk as well.
of instruments, including swaps, put options
and collars, among others.
Issue 02 | 3

4. 4 | Issue 02
95 –
115 –
135 –
155 –
35 –
55 –
75 –
Apr. 2007 –
$/ BBL
Swap
Jun. 2007 –
Aug. 2007 –
Oct. 2007 –
Swap
Market Price
Dec. 2007 –
Feb. 2008 –
Apr. 2008 –
Jun. 2008 –
Aug. 2008 –
Oct. 2008 –
Dec. 2008 –
Crude Oil
Feb. 2009 –
Apr. 2009 –
Jun. 2009 –
Aug. 2009 –
Costless Collar
Market Price
Collar
Oct. 2009 –
Costless
Dec. 2009 –
Feb. 2010 –
HedGInG exAMples
Natural Gas
Apr. 2010 –
Jun. 2010 –
Aug. 2010 –
OIl & GAs vOlAtIlItY: NYMeX
Oct. 2010 –
Dec. 2010 –
Feb. 2011 –
Data: Mercatus Energy Advisors
Apr. 2011 –
–2
–4
–6
–8
– 14
– 16
– 12
– 10
Put Option
Put
$/ MMbtu
Option
Market Price

5. 5 Companies should not solely depend on their that hedging should not be considered a source
banks or trading counterparts to provide hedg- of revenue. A well-designed hedging strategy
ing strategies that are an ideal fit. Banks and should provide cash flow and revenue certain-
trading companies take the opposite side of ty, the ability to lock in profit margins and/or
their customer’s hedges, which means the bank protect against declining prices, not to gen-
or trading company’s best interest may not erate profits. If an e &P initiates a hedging
align with the best interests of the customer. program for profit, it has become a speculator.
simply accepting the exact hedging structure
suggested by the bank or trading company is The vast majority of hedging mistakes are the
rarely in the company’s best interest. result of a poor or nonexistent hedging policy
or failing to abide by the policy. Most hedging
mistakes can be avoided if the company takes
the time and effort to create a proper hedging
“ It Is crucIal that policy and to develop and implement strate-
hedgIng not be gies that allow it to meet its hedging goals and
consIdered a source objectives.
of revenue.”
e &Ps will be well served to create and imple-
ment sound hedging and risk management
When an e &P decides to develop a hedging policies, or review and reassess policies that
program, one of the main challenges is iden- are already in place, to make certain they are
tifying the best types of hedging instruments mitigating their exposure to energy price risk
that will allow the company to meet its busi- (as well as credit, regulatory, operational and
ness objectives. basis risk) in today’s uncertain economic en-
vironment. $
The first step is determining the company’s
risk tolerance as well as its hedging goals and Michael Corley is veteran energy trader and
objectives. specifically, what is the company founder and president of Mercatus Energy
seeking to accomplish by implementing hedg- Advisors LLC (formerly EnRisk Partners), a
ing program? Is it to reduce cash flow volatil- Houston-based energy trading and risk man-
ity? To guarantee a minimum revenue stream? agement firm. Prior to founding the firm, he held
How much upside is the company willing to various roles in energy trading, marketing and
give up to reduce or eliminate exposure to low risk management with El Paso Merchant Energy,
prices and/or volatility? Only after answering Cantor Fitzgerald, and several energy consulting
these questions, as well as many related ques- firms. • 713.970.1003 • MercatusEnergy.com
tions, should an e &P discuss what hedging
instruments to use.
pItfAlls
In addition, there are a number of common,
hedging mistakes that e &Ps need to avoid
at all costs. First, it is crucial to remember
Issue 02 | 5

6. Issue 02 | May 2011
excerpt from
The Global Commodities Report
Issue 02 | May 2011
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Coal www.the-Gcr.com
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