by Michael Corley

presents

to hedge

to hedgeor Not

to hedge

to hedgeor Not

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.

Hedging advice for oil & gas CFOs

2 | Issue 02

s the energy markets continue to evolve, the question of whether to hedge, or not to hedge, continues to

challenge exploration and production compa-nies (e &Ps).

Historically, many have argued that e &Ps serve as vehicles for obtaining exposure to energy commodity prices. However, in recent years, industry best practices have evolved and the new consensus is that e &Ps must take their own proactive steps to mitigate risk, in-cluding commodity price risk.

There’s no question that management teams and investors alike detest the idea of not be-ing able to reap the benefits of “high” energy prices. And rightfully so. On the other hand, “low” and/or volatile prices can be one of an e &P’s worst nightmares.

The key to a successful hedging program is developing and implementing strategies that perform as intended in both high- and low-price environments, as well as in between. That typically means utilizing a combination of instruments, including swaps, put options and collars, among others.

OverlOOked Aspects

In our firm’s daily discussions with companies across the globe, there are several key aspects of hedging that we tend to highlight because they are often overlooked or misunderstood:

5 The structures of hedges are crucial. There are significant differences, such as basis, credit and operational exposure, in the various hedg-ing structures available to e &Ps – differences often overlooked by companies.

5 so-called exotic hedges, most of which in-volve the selling of options, either direct or indirect, can lead to a disaster if the structures are not completely understood by the manage-ment team.

5 e &Ps must “stress test” their hedge portfo-lio so that the performance of both individual hedge positions, as well as the entire portfolio, are well understood in all potential price envi-ronments. These tests should not only include price (market) risk, but basis, credit and op-erational risk as well.

A

by Michael corley

Founder and President of Mercatus energy Advisors LLC

Issue 02 | 3

155 –

135 –

115 –

95 –

75 –

55 –

35 –

– 16

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$/MMbtu$/BBL

Apr

. 200

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200

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. 200

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. 200

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Dec

. 200

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200

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201

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. 201

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Data: Mercatus Energy Advisors

Crude Oil Natural Gas

OIl & GAs vOlAtIlItY: NYMeX

HedGInG exAMples

Swap

Swap

Market Price

Put Option

Put Option

Market Price

Costless Collar

Costless Collar

Market Price

4 | Issue 02

5 Companies should not solely depend on their banks or trading counterparts to provide hedg-ing strategies that are an ideal fit. Banks and trading companies take the opposite side of their customer’s hedges, which means the bank or trading company’s best interest may not align with the best interests of the customer. simply accepting the exact hedging structure suggested by the bank or trading company is rarely in the company’s best interest.

When an e &P decides to develop a hedging program, one of the main challenges is iden-tifying the best types of hedging instruments that will allow the company to meet its busi-ness objectives.

The first step is determining the company’s risk tolerance as well as its hedging goals and objectives. specifically, what is the company seeking to accomplish by implementing hedg-ing program? Is it to reduce cash flow volatil-ity? To guarantee a minimum revenue stream? How much upside is the company willing to give up to reduce or eliminate exposure to low prices and/or volatility? Only after answering these questions, as well as many related ques-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

that hedging should not be considered a source of revenue. A well-designed hedging strategy should provide cash flow and revenue certain-ty, the ability to lock in profit margins and/or protect against declining prices, not to gen-erate profits. If an e &P initiates a hedging program for profit, it has become a speculator.

The vast majority of hedging mistakes are the 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 policy and to develop and implement strate-gies that allow it to meet its hedging goals and objectives.

e &Ps will be well served to create and imple-ment sound hedging and risk management policies, or review and reassess policies that are already in place, to make certain they are mitigating their exposure to energy price risk (as well as credit, regulatory, operational and basis risk) in today’s uncertain economic en-vironment. $

Michael Corley is veteran energy trader and founder and president of Mercatus Energy Advisors LLC (formerly EnRisk Partners), a Houston-based energy trading and risk man-agement firm. Prior to founding the firm, he held various roles in energy trading, marketing and risk management with El Paso Merchant Energy, Cantor Fitzgerald, and several energy consulting firms. • 713.970.1003 • MercatusEnergy.com

It Is crucIal that hedgIng not be consIdered a source of revenue.”

“

Issue 02 | 5

Issue 02 | May 2011

+12 Other Features » A Trio of Top TSX Junior Miners • Energy Hedging Tips for CFOsAg Minister Interview • Mexico & Montana Momentum • New Analyst Investor Scorecard

Ancient Fuel,New OpportunitiesCoal

excerpt fromThe Global Commodities ReportIssue 02 | May 2011

Published by New Vanguard Media Inc.

www.the-Gcr.com