Drilling Into Chesapeake’s Natural Gas Hedging Program

Chesapeake Energy (NYSE:CHK) has prided itself as having one of the best performing hedging programs in the industry. Historically, the program has allowed the firm to not only stabilize price realization and cash flows but also profit from natural gas price movements. Between 2006 and 2011, Chesapeake earned around $8 billion from derivatives trading alone. ^[1] However, things took a turn for the worse in 2012 when wrong way bets (and price volatility) cost the firm dearly. Here is a quick review of the firm’s hedging program, its structure and why we think it’s important to Chesapeake despite the recent uptrend in gas prices.

A Lesson From 2012

Like most energy commodities, the direction of natural gas prices is difficult to forecast. Prices depend on weather conditions, supply and inventory levels, prices of alternative fuels and consumer and industrial demand, among other factors. This makes its imperative for natural gas producers to have an effective hedging program to stabilize cash flows and protect themselves against adverse price movements.

In 2011, Chesapeake boldly predicted that gas prices would increase in early 2012 due to the weather-driven jump in demand and removed most of its gas hedges being fully exposed to price fluctuations. This proved to be a huge mistake. Gas prices ended up falling from around $3.5/ MMBtu in Q4 2011 to their 10-year lows of around $2 in early 2012. These prices were below Chesapeake’s operating costs and had a severe impact on the company’s margins and cash flows. By May 2012, the firm had said that it was running out of cash and would need to sell assets and raise additional debt to make up for the shortfall. Chesapeake’s  bargaining power in most of its asset sales ended up being extremely low since buyers were aware of its high leverage debt and low cash flows. For instance, the firm sold part of its stake in the Mississippi Lime shale formation to China’s Sinopec (NYSE:SHI) for a price that was around 60% lower than the firm’s initial valuations. (See Also: After Chesapeake Gives Sinopec A Sweetheart Deal Are More To Come?)

Partly Hedged This Year, A Prudent Move Despite Rising Gas Prices

For 2013, Chesapeake has hedged around half of its estimated natural gas production at an average price of around $3.6 per mcf. We believe that this is a prudent move despite the fact that natural gas prices have been trending higher in recent months (prices have risen from ~$ 3.5 in January to current levels of ~ $4), since the firm’s priority in the near term should be on managing cash flow and reducing debt load rather than heavily exposing itself to natural gas price volatility.

According to Chesapeake’s financial projections for 2013, cash operating costs will be around $1.7 per mcfe (on the higher end) while total production operating expenses, including depreciation and non cash charges, are expected to be between $3.4 and $3.9 per mcfe. ((Chesapeake)) Given that the production is hedged at around $3.6 per mcf, the firm should be able to comfortably cover its cash expenses and generate some cash from its natural gas production operations.

How Hedging Is Done

While there are various derivatives instruments that can be used to lock in future prices of a commodity, Chesapeake currently relies on swaps and three-way collars to manage its natural gas price exposure.

Swaps: The price of around 45% of  Chesapeake’s estimated gas production for 2013 is locked in using swaps. The structure is fairly straightforward. Chesapeake receives a fixed price (around $3.63/mcf) and pays the counterparty to the swap the floating market price for natural gas. ^[2] Swaps do not allow the firm to cash in when gas prices rise.

Three-way collars: Chesapeake has hedged around 5% of its 2013 production using three-way collars, which involve buying a put option and selling a call option along with another out-of-the-money put option. The motive for this trade is to reduce the total hedging costs since the premium collected on the call and put options that the firm writes out defrays part of the cost of the put option that it purchases for downside protection. The firm’s current contracts effectively cap the upside at around $4.03 per mcf while limiting the firm’s downside, if gas prices fall, to around $3.55 per mcf. There is however an element of risk with three-way collars since the firm bears some risk on the further out-of-the-money put option that it writes out. If gas prices fall below the strike price (around $3.03 on current contracts), Chesapeake will have to pay the difference to the counter party.

We have a $21 price estimate for Chesapeake which is in line with its current market price.

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1. CNBC [↩]
2. Chesapeake Form 10-K [↩]