Unlocking the value of oil and gas hedges
Now is the time to consider monetizing this valuable asset as a source of funding for 2015 operations
Jay Snodgrass, EnerFi Capital, New York, NY
AJ McNally, ClearHedging, Red Bank, NJ
With WTI breaking $45 earlier this year and hovering around $50 recently, many CFOs will struggle to fund operations in the coming months. In the current pricing environment, it has become more difficult to generate a positive risk-adjusted return from new drilling. This has led nearly every company to plan significant reductions to drilling budgets for the coming year.
Many companies, however, have existing obligations that leave them little choice but to either drill uneconomic wells, pay delay rentals, or risk losing valuable leases. With capital markets closed to all but the highest-rated companies, many CFOs are considering non-traditional funding options to meet these obligations.
Fortunately many prudent operators put into place hedges that have insured cash-flows during this period of depressed commodity prices. However the value underlying these hedges is only realized on a month-to-month basis as contracts expire. For companies with ample liquidity this is fine, and monetizing hedges for these firms is generally not recommended as there is a cost to the process. However, for firms in need of immediate capital, hedge monetization can provide a significant lump-sum payment. Further, the cost is typically lower than alternative sources of capital and can be completed in a matter of days rather than weeks or months.
Maximizing net proceeds from a hedge book monetization requires specialized expertise and finesse. The first step in the process is to calculate an accurate valuation of the existing portfolio of hedges. Next it's important to structure a new dynamic hedging program to ensure that production continues to be hedged throughout this volatile period. In addition, companies that have credit facilities in place will need to negotiate with lenders to minimize a likely reduction in borrowing base. Finally, it's important to minimize execution costs through price negotiation with counterparties, which can result in tens of thousands of dollars of additional liquidity.
Accurately valuing the existing hedge portfolio is critical as this is the source of proceeds. Most counterparties are large commodity trading desks that use sophisticated models to value hedge portfolios. As with any over-the-counter product, the pricing of derivative contracts is inefficient. Operators that aren't able to accurately value their portfolio prior to negotiating the unwinding with counterparties are at a significant disadvantage and could be leaving substantial money on the table. Given the complexities involved, it's generally advisable to have an independent qualified advisor on hand to ensure best practices are implemented and maximum valuation achieved.
During the monetization process many companies will be tempted to believe that oil has found a floor or that "it can't go any lower" and will therefore be reluctant to put on new hedges. This is a dangerous trap that can spell future disaster. Hedging against lower prices is insurance against the systemic risk of an uneconomic business. Each operator has different pain points and the new hedge program should be customized to protect against those particular pain points.
It's important for operators to understand that hedges are simply an asset, in the form of insurance, that in most cases today has paid off handsomely.
Now is the time for many oil and gas companies to consider monetizing this valuable asset as a source of funding for 2015 operations. Companies such as EnerFi Capital, ClearHedging, and others provide independent advice to operators interested in maximizing net proceeds from hedge monetization and implementing a dynamic hedge program to achieve ongoing protection throughout this volatile period.
About the authors
Jay Snodgrass ([email protected]) is an investment manager, speaker, and writer. He is the founder and principal of EnerFi Capital, which provides specialized financial advisory services to clients in North American oil and gas development. Previously, Snodgrass worked in upstream private equity focused on joint venture investments in onshore drilling. He earned a BBA degree in finance and CIS from the University of Miami.
AJ McNally ([email protected]) is the founder of ClearHedging. He brings a depth of experience in analytical research, client relationships, leadership, management, and market knowledge. He began his career in New York City with E.F. Hutton and Citibank as an equity analyst where he valued and sold assets held in trust and estates. In his 30-year trading career, McNally has traded futures and options on the NYMEX, COMEX, and NYBOT in various energy, metal, and soft products, including natural gas, crude oil, gold, silver, cotton, and sugar. He holds a degree from Villanova University's business school.