US oil and gas companies reevaluate hedge strategies

James M. Vanderhider, EnerVest executive vice-president and chief financial officer, called hedging a conscious decision to lock in price certainty for specific production volumes-based on the realization that prices can move up or down.

“Obviously, we are at very lofty levels now relative to historical commodity price levels,” Vanderhider said. “We don’t really know future prices. But if we can lock in a hedge position at a price above what we paid for the reserves then that provides more cash flow to our investors.”

The hedge contracts EnerVest entered during the last 2 years involve prices “well above our acquisition pricing for the underlying reserves that we bought, so it’s very accretive to rate of return,” he said.

Typically, EnerVest hedges for 12-18 months although the contract duration depends upon where EnerVest executives see themselves within the commodity price cycle.

EnerVest believes that hedging is a risk management tool and that positions should be established over time as commodity developments occur.

For various institutional funds, EnerVest maintains an agreement that outlines risk management specifics. Vanderhider noted that rising oil and gas prices have made some funds willing to commit to 3-year hedges; earlier, they would have limited hedge commitments to 18 months.

Typically, EnerVest does not hedge more than 75-80% of its overall current production.

“You benefit because you still get your price on your hedged volumes, and you get an even higher price for your unhedged volumes,” he said of the current situation.

“We hedge as we make acquisitions, and then we add supplemental hedges thereafter as development occurs,” Vanderhider said. “For rate-of-return protection, we are continuing to follow that discipline.”

EnerVest plans to close on two acquisitions by yearend, both of which involve hedging.

Hedge accounting

In the US, companies using hedges follow complex, technical accounting guidance established by the Financial Accounting Standards Board. Hedge accounting involves an exception to the usual rules for financial instruments. Strict criteria must be met before hedge accounting can be used.

FASB Statement No. 133 establishes accounting and reporting standards for derivative instruments. It requires a company to recognize all derivatives as either assets or liabilities on financial statements, depending on whether current commodity prices are above or below the overall hedge value.

For example, this year oil and gas prices climbed above most companies’ hedge prices. For any such company, the price relationship created a liability because of the prospective need to cover forward contracts now undervalued relative to the market. Hedge accounting standards require the company to account for the deficiency as a charge against earnings with the effect of reducing balance-sheet value, or equity.

That’s why the earnings of many companies in the third quarter suffered even though prices of oil and gas were rising.

Under hedge accounting, hedges hurt by adverse price relationships are called ineffective. Hedge ineffectiveness can arise for various reasons and does not directly correlate to whether a hedge is making or losing money.

FASB’s guidance outlines differing hedge accounting treatment depending upon whether the hedge is deemed effective or ineffective.

When a hedge becomes ineffective, a company must adjust its income to reflect the value change.

Companies periodically use an accounting process known as mark-to-market to determine whether the contract is above or below the market price. For instance, if a company hedged its oil at $50/bbl and the price of crude ran up to $70/bbl, the hedge would have a mark-to-market negative value of $20/bbl.

Hedge accounting reflects the deficiency as a noncash charge against earnings with the effect of reducing equity.

S&P’s Watt said, “The resulting financial reporting requirement of these ‘ineffective’ hedges can obscure the operating performance of any company.”

Third-quarter charges

Partly because of ineffective hedges, for example, Forest Oil Corp., Denver, reported Nov. 9 that accounting regulations required it to take a $72.1 million pretax, noncash charge.

The total included $42.8 million associated with the discontinuance of hedge accounting related to 2005 hedges on production deferrals caused by Hurricanes Katrina and Rita.

A further $23 million of unrealized losses related to several collar agreements that did not qualify for cash flow hedge accounting, and Forest reported $6.3 million of measured hedge ineffectiveness.

Forest reported 2005 third quarter net earnings of $3.3 million. Without the effect of special items, Forest’s adjusted net earnings would have been $50.2 million.

Hurricane activity in the third quarter deferred 6 bcf of gas equivalent production. Meanwhile, Forest is spinning off its Gulf of Mexico operations, which Mariner Energy Inc., Houston, plans to acquire (OGJ Online, Sept. 12, 2005).

The Mariner transaction is expected to close during first quarter 2006, at which time Mariner will assume Forest’s gulf-related hedges.

Watt said Forest has consistently used swaps and collars covering 40-56% of production for the past few years.

In a swap, a producer agrees to sell production at a fixed price to a counterparty, usually a bank, and to make payments to the counterparty based on market prices, which it hopes remain below the fixed-payment rate. A collar in effect sets ceiling and floor prices with the strategic use of forward trading instruments such as options.

Watt said heavy reliance on swap positions exposes a company to significant lost upside potential at any price above the swap price.

Collars provide a wider zone with a ceiling price that is typically higher than the fixed swap price, and collars reduce the effect of rising commodity prices on the value of the hedge.

“Forest Oil was out of the money in its swap position for the first half of the year,” Watt said. Yet he noted that Forest’s swaps and collars provided “effective risk management levers given the company’s cost structure.”

For the first half of 2005, Forest Oil held a majority of swap contracts for its oil and gas hedges. A locked-in swap price of around $35/bbl of oil exposed Forest to a potentially lost upside of $25/bbl at $60/bbl prices, Watt said.

Restructured hedges

Companies can restructure hedging contracts. The cost of restructuring hedges emphasizes the importance of maintaining near-term hedge positions, Watt said.

“Companies face a tradeoff between forgoing potential cash flow and paying off counterparties to exit unfavorable contracts,” Watt said.

For example, Plains Exploration & Production Co., Houston, twice rewrote its 2005-06 hedge contracts within 7 months during 2004-05.

Plains Exploration uses hedges to offset higher regional lifting costs and to mitigate a negative differential that its crude oil receives relative to crude oil prices on the New York Mercantile Exchange.

Traditionally, Plains Exploration entered hedge agreements for several years. But long-term contracts became undesirable given “the magnitude of the upward commodity price trends beginning in 2004,” Watt said.

Consequently, Plains Exploration restructured its hedge positions to improve future realized cash flow and earnings.

For the third quarter 2005, Plains Exploration reported a net loss of $31.8 million compared with a net loss of $47.9 million for the third quarter 2004.

The 2005 third-quarter results reflected a $141.6 million pretax loss on mark-to-market derivative contracts. Cash payments related to the mark-to-market derivative contracts that settled during the quarter totaled $101.4 million. There was a $25.3 million pretax noncash charge to revenue related to oil and gas hedges.

The company noted that production was lower for the third quarter 2005 than for the same period last year because of asset sales and hurricane-related shut-in production.

Production delays

Other companies with gulf production also found themselves facing hedges backed by shut-in production because of hurricane damage to infrastructure, sometimes third-party pipelines and processing plants.

Watt believes companies will be fine once normal production rates are resumed.

“It’s not a painful amount if you look at the overall operating income, and it’s not a cash impact,” he said in general of gulf operators’ hurricane-related accounting losses

Kerr-McGee Corp. reported an after-tax charge of $66.8 million associated with projected gulf gas deliveries in the fourth quarter that will be less than its hedged volumes for those fields.

“The company believes that it is probable that deliveries in the Gulf of Mexico will resume in sufficient volumes to match its remaining 2006 and 2007 derivative contracts by January 2006,” Kerr-McGee said.

It said it “also recognized an after-tax loss of $137.7 million in the third quarter for hedge ineffectiveness, representing the excess of the mark-to-market loss associated with all outstanding derivative contracts accounted for as hedges over the expected higher revenues the company will receive on its future sales of oil and natural gas.”

In a Nov. 1 report, S&P credit analyst Jeffrey Morrison said record high oil and gas prices will help Kerr-McGee achieve its 2005 financial targets.

“In addition, the company has sufficient liquidity to cushion it from any near-term financial shortfall associated with the production delays,” Morrison added.

Newfield Exploration Co. announced hurricane-related deferral of 18-20 bcf of 2005 gas-equivalent production. But high prices are expected to replace the lost cash flow, Morrison said.

In addition, a third-quarter pretax charge of $205 million, a portion of which is related to the loss of hedge accounting for contracts on deferred production, is largely noncash, Morrison said.

Hedging operating costs

Some producers use hedging to ensure a rate of return as they seek to manage rising service, exploration, and operating costs.

For instance, Anadarko Petroleum Corp. implemented hedges on crude oil production as protection against rising costs of deepwater drilling rig contracts. “We see a rapidly tightening market for these high-end capability rigs, and we believe having equipment firmly committed under our control will provide a financial and competitive advantage,” said Anadarko Pres. and Chief Executive Officer James T. Hackett.

Companies having prospects are likely to team with companies having rigs, he said.

“We recognize that there is some concern that rig rates are approaching cyclical highs,” Hackett said during an earnings conference call.

“In the third quarter, we added some oil hedges spanning the contract periods,” Hackett said. “The idea is to hedge just enough so that any drop in value of rig contracts would be offset by market value gains of the oil hedges since the two tend to move in opposite directions.”

Anadarko announced $90 million after tax of unrealized losses on derivatives for the third quarter.

“Anadarko’s results were strong, even with the impact of several noncash items and unusual events, not the least of which were two 100-year storms in one quarter,” Hackett said.

Chesapeake Energy Corp. is known for what it hails as its “proactive” approach to hedging. As of early November, Chesapeake had 73% of its production hedged for the fourth quarter and 50% hedged for the first quarter 2006.

“We have tried to mitigate our exposure to rising service costs, but you can’t hedge that out completely,” said Jeffrey L. Mobley, vice-president of investor relations and research.

He said acquisition-related hedges accounted for most of the Oklahoma City producer’s hedges before the posthurricane run-up in commodity prices.

Changing tactics

Watt said the complexities involved in choosing a risk-management strategy are unique to each company and must be evaluated on an individual basis rather than as a comparative measure between companies.

“In some ways, people would expect a company going out and hedging to be a good thing. In many cases, it’s not necessarily a good thing,” Watt said. “It can be helpful for companies that are small and exposed to price swings. But for larger companies, there are benefits, and there are drawbacks to hedging.”

XTO Energy Inc., Fort Worth, has implemented hedging contracts on smaller production volumes as the company has grown. This year, XTO has less than 30% of its production hedged.

In 2001, XTO needed to hedge 80% of its gas production volumes to ensure the cash flow and revenues to accommodate its drilling budget.

Gary Simpson, XTO vice-president of investor relations and finance, said, “We haven’t needed to hedge as much from a volume side to assure our growth.... You always can expect XTO to hedge some volumes but not at the scale that we used to put on as a smaller company.”

Many companies, XTO included, have turned increasingly toward an acquisition-position hedging strategy.

Years ago, Apache Corp. made that shift (OGJ, Aug. 13, 2001, p. 23). This year, Apache has hedge contracts on less than 10% of its worldwide production volumes.

S&P’s Watt said, “Recent spikes in oil prices have showed how market unpredictability and the associated threat of forecast error can mitigate the effectiveness of hedges as a risk-management tool. Some companies are willing to tolerate this risk of forecast error in favor of future cash flow protection, while other rooted in the wildcat, risk-seeking tradition of the E&P business prefer to remain unhedged.” ✦