Oil patch's thorny issue: the hedge

www.globeandmail.com By DEBORAH YEDLIN Monday, January 20, 2003 – Page B2

To hedge or not to hedge. That is the question in the oil patch these days because commodity prices are miles ahead of what was used to determine capital budgets for 2003.

In most instances, oil prices of $21 (U.S.) or $22 a barrel or natural gas prices around $3 per thousand cubic feet were plugged into capital spending programs for the coming year. But since that budgeting period -- which usually happens during the fourth quarter -- prices have jumped. No one expected oil would average $26.15 in 2002, much less hit $34 last week.

The high prices -- a result of political strife in Venezuela, higher than expected inventory drawdowns and continued sabre rattling in the Middle East -- are presenting energy companies with the unheard-of opportunity to hedge oil production for the rest of the year at prices close to $29 a barrel.

The high prices mean billions of dollars in extra cash flow for the oil patch, not to mention the Alberta government's coffers. Yet even with those heady prices, companies aren't exactly rushing to crystallize those gains.

Although locking in a guaranteed rate is something mortgage holders are encouraged to do so they know exactly what their fixed costs are, the same logic doesn't necessarily apply in the world of the oil and gas producer.

Some companies even have stated policies that they do not hedge. Period.

Some of this might be because of a perception that hedging is done by the faint of heart who can't bear the commodity price risk. Then there is a fear of hedging at too low a price, which means leaving dollars on the table. Finally, no one wants to stand up at the annual general meeting with a red face and address the issue of hedging losses.

On this one, the oil patch appears stuck between a rock and a hard place.

It's an industry where the risk/reward ratio is always front and centre, with a tendency to play the risk variable a little harder than in other businesses.

And when it comes to hedging, the view is often that you just can't win either way.

On the one hand, the market has shown itself unwilling to pay up for sudden spikes in commodity prices, especially over the past couple of years. Shares in oil and gas companies have continued to trade at levels reflecting oil prices in the low $20-a-barrel range, and not the average $26.05 of the past two years.

On the other hand, the market also doesn't reward companies that put hedges in place that have worked in their favour; risk management is all part of sound business practices, and when investors buy shares in an oil and gas company, it could be argued that they are buying management first and the assets second.

Still, from a purely logical perspective, why not take advantage of the market's willingness to lock in at a price that is very rich compared with historical standards, even if some of the upside is shaved off the price peak? The reality is, companies have never before been able to lock in oil production for an entire year at a price approaching $30 a barrel.

By not taking advantage of it because the price might move even higher looks a bit like greed has overtaken fear.

But on this issue, there are as many opinions as there are analysts.

Some, such as Tom Ebbern of Tristone Capital, argue that companies should take advantage of an opportunity to offer enhanced consistency of results; others call it a mug's game because companies are penalized if they make what turns out to be the wrong call on commodity prices.

Although commodity prices and capital budgets remain the primary drivers for making hedging decisions, another factor in the equation is the ability to put the hedge in place. The short story is that it isn't as easy, or as cheap, as it was only 12 months ago because of the disappearance of companies such as Enron, Dynegy and Williams Cos., which acted as counterparties to the hedges by taking on the commodity price risk.

Although the gap in Canada has been filled to some extent by the banks, the liquidity in the market has dried up significantly with the result that the credit requirements are more significant.

Still, as all the forecasters at the annual dinner held by the Calgary Society of Financial Analysts last week pointed out, troughs follow peaks -- and that should be enough to answer the question of whether or not companies would be well advised to take advantage of the price curve and hedge their bets. dyedlin@globeandmail.ca