Many upstream oil and gas companies enter into derivative contracts to hedge some of their commodity price risk. This article serves to explain how to explain the basics of the types of hedges that exist and how they affect a company’s cash flows.
One of the most common types of hedges that upstream companies enter into is called a “collar.” A collar both limits a portion of a company’s downside and a portion of a company’s upside. The following table is from Range Resources’ 2012 10-K. The company stated that for 2013, it had hedged 280,000 MMBtu/day (millions of British thermal units per day) of natural gas with collars at $4.59-5.05/MMBtu. This means that even if natural gas prices fall below $4.59/MMBtu, the minimum that RRC would receive is $4.59/MMBtu on 280,000 MMBtu/day of production.
The below excerpt from Range Resources’ 2012 10-K shows the hedges that the company has entered into:
To illustrate how the collar works, let us assume that the price of natural gas was flat at $4.00/MMBtu throughout 2013 and Range produced only 280,000 MMBtu per day (the amount hedged with the collar). Without the hedge, RRC would receive 280,000 * 365 days * $4.00 = $408.8 million. Because RRC has entered into a collar guaranteeing a minimum price of $4.59/MMBtu for natural gas, RRC’s hedged revenue would actually be 280,000 * 365 days * $4.59 = $469.1 million, which is $60.3 million higher. In this case, where the actual price of natural gas was lower than the floor price of the collar, RRC capped some of its downside and benefited by ~$60 million from entering the hedge.
On the other hand, if natural gas prices were $6.00/MMBtu throughout 2013, RRC’s revenue would have suffered from entering into the hedge. That is, instead of receiving 280,000 * 365 days * $6.00 = $613.2 million, RRC would have received 280,000 * 365 days * $5.05 (the ceiling price) = $516.1 million. In this case, RRC missed out on $51.1 million because of the collar.
The top chart shows what the theoretical payoff structure, for this example, would be in graphical form. Assuming RRC produced only 280,000 MMBtu/day of natural gas during 2013, with this collar its maximum natural gas revenue would be ~$516 million and its minimum natural gas revenue would be ~$469 million. In practice, RRC would probably produce more than 280,000 MMBtu/day of natural gas as companies generally do not hedge 100% of their production. This example assumes that RRC produces exactly the amount that it has hedged to come up with the minimum and maximum revenue amounts.
Upstream companies enter into collars to protect their downside. Buying puts (also known as floors) also achieves the same objective. However, by also selling a call, thereby capping upside, upstream companies can reduce the cost of the hedge.
Market Realist will continue this introduction to oil and gas hedges in future articles.
© 2013 Market Realist, Inc.
But if I knew how to manage my portfolio safer and smarter than most hedge fund managers, I could realistically grow my wealth.