What You Need to Know About Oil & Gas Hedging


To Hedge or Not to Hedge
While some may see hedging as a complicated and advanced investing strategy, the principles behind hedging are in reality very simple. Hedging commodities allows investors to ensure predictable financial results by protecting against future price movements. By purchasing futures contracts, investors can lock in prices that are favorable to an organization to continue realizing profits over time. While limiting exposure to financial losses also limits the potential for gains, it does help protect investors during periods of market volatility.

Benefits of Hedging
Hedging is particularly valuable in oil and gas commodities to help investors achieve predictable financial results. Depending on the size and nature of an organization, a well-defined hedging program could help encourage growth and profitably even during periods of relatively flat prices. While larger conglomerates may not need to rely on hedging to ensure profitability, giving that its investment activities can help drive the market, a smaller company can see great advantages from hedging as usually its long or short position has minimal or practically no impact on the market prices.

The natural gas market is a great example of where hedging has helped companies continue to realize profits in periods of recent price volatility. For example, the polar vortex of 2013-2014 saw volatility in a market that had long been flat. Natural gas futures contracts on the NYMEX had been trading under $4/mmBtu since January of 2012. However, February 2014 saw prices close to $6/mmBtu, from a low in January of $3.10. The eastern United States saw some local supplies surging as much as eightfold as demand for heating soared during periods of extreme cold. In these types of market movements, a well defined and an active hedging program can ensure maximum value is captured for investors.

Some Common Tools Used for Hedging
Various tools are used to manage hedging programs, depending on their complexity.

Futures/Forward Contracts

Futures are a standardized agreement to purchase a specified asset of standardized quantity, on a specific date at a specific price. Futures contracts are exchange traded and are guaranteed by a clearinghouse, which minimizes the risk of counterparty default.
Forward contracts are private agreements between two parties and are not as rigid terms and conditions as a futures contract, and there is a chance that the other counterparty might default on its commitment.

Options

Options are a more flexible hedging tool. A company or investor can purchase a ‘call’ option, which is the right to buy an asset at a particular price, or a ‘put’ option, to sell at a particular price at a future date. Unlike futures, the option owner is not required to follow through with the transaction if the market price is more advantageous than the option price.

Should You Be Hedging?

The appetite and willingness for market risk is the biggest factor in deciding whether or not to embark on a hedging program. Smaller companies looking to protect themselves from wild market fluctuations and volatility would be well served by at least investigating what a well-defined hedging program could bring to the business. However, market participants of all sizes need the ability to smooth the ups and downs of future financial results, as businesses can’t grow on unpredictable financial results and a well-defined hedging program is still better than hoping that the market moves in your favor.