Hedges Pay Off for Natural-Gas Producers

NEW YORK (THE WALL STREET JOURNAL via Dow Jones Newswires), Aug. 12, 2009

For oil and natural-gas companies, the budding crackdown on U.S. energy markets comes at an awkward time.

Producers are relying more than ever on the futures markets to hedge the risk that prices will fall, even as regulators take aim at energy traders in an effort to blunt the sort of spikes that hit consumers last year.

Recent earnings reports from a number of U.S. companies -- including El Paso Corp., XTO Energy Inc., and Chesapeake Energy Corp. -- showed a big boost from deals that locked in high prices for natural gas before that market sank to seven-year lows.

Those hedges in effect guarantee the amount of revenue the companies will receive on their production, bringing some financial stability to an inherently risky business.

But producers need active speculators to complete those deals. Under long-term hedging plans, producers agree months or years in advance to sell oil and gas at a certain price. Those trades are only possible if there's a buyer on the other side, one who by definition is probably betting that prices will rise.

The situation shows how efforts to protect consumers from soaring energy prices could have unintended consequences. Chesapeake is among those warning that a poorly thought out rush to lock the doors to energy speculation could diminish the depth of the market, hinder the company's ability to secure the best price and deprive it of the "cash-flow certainty" that allows it to fund the ambitious drilling programs that bring on new supply.

"Chesapeake has serious concerns regarding how position limits on energy futures and a more restrictive application of hedge exemptions would impact how we deploy our risk-management strategy," corporate finance manager Elliot Chambers argued in written testimony before the Commodity Futures Trading Commission on Aug. 5.

Had the company not been able to lock in gas sales to offset the risk of falling prices, a $3.75 billion investment leading to the 2008 discovery of prolific new gas supply in Louisiana "would not have been possible," Mr. Chambers contended.

Hedges can hurt in bull markets, but they have paid off richly in recent months, as oil and natural-gas prices fell from last year's historic highs. El Paso's hedges contributed five cents of the 11 cents a share in second-quarter net income the company reported Thursday, said Bruce Connery, vice president of investor relations.

El Paso said hedges for 70% of the domestic gas it expects to produce in the second half of the year will bring in $9.02 per million British thermal units. Gas futures settled at $3.541 Tuesday in New York. At the end of the first half, gas was down 71% from a year ago.

XTO said Aug. 5 it booked an average gas price of $7.08 in the second quarter thanks to hedging transactions. The company has locked in an average price of $8.67 on more than a quarter of the gas it expects to produce next year. XTO also hedged its crude-oil production, guaranteeing an average price of $107.14 a barrel this past quarter. Oil prices are now around $70 a barrel, down by about half from their record level last summer.

On Aug. 3, Chesapeake said it swung to a second-quarter profit thanks in part to its "successful hedging program." Its $243 million in net income included a gain of $597 million on gas and oil hedges.

Critics aren't moved. They argue the wave of speculative investment in oil and gas futures has produced wild swings in prices unrelated to supply and demand. They also argue the volume of speculation dwarfs the interplay between actual producers and consumers of energy.

Concerned about the market swings, the Commodity Futures Trading Commission has been holding hearings to consider whether to place restrictions on how energy futures are traded. Most of the talked-about limits would restrict the activities of financial investors such as hedge fund traders or institutions that have no intention of making or taking delivery of the commodities they are selling or buying.

John Arnold, manager of $5 billion energy hedge fund Centaurus Advisors and a major natural-gas trader, testified before the CFTC on Aug. 5 that the willingness of traders like himself to take big risks is critical if producers are to finance investments in domestic energy supplies. If trading limits are sharply tightened, he says, it would take many more speculators to make up the other side of transactions with big-volume hedgers like Chesapeake.

El Paso declined to comment on the regulatory proposals. XTO spokeswoman Nicki Northcutt said "hedging is an integral part of our business strategy" and "we are keeping an eye on things" as regulatory changes are debated in Washington.  

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