Removing Risk: Hedging Capital Investments in Unconventional Gas Projects

To manage the risks associated with unconventional gas development projects, many companies employed a variety of hedging programs. Although these hedging initiatives were intended to maintain capital stability in long-term projects, many upstream companies have felt compelled to curtail their capital programs in the face of the collapse in energy commodity prices. A more effective alternative for these companies would have been to implement a hedging program directed at the needs of the capital program and not at the underlying commodity that would later be produced. Such hedging of targeted risks in capital projects can reduce margin volatility of project returns and help provide stability in volatile price and constrained capital environments.

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Andrew Steinhubl Justin Pettit John Corrigan Mark Uffhausen

Removing Risk Hedging Capital Investments in Unconventional Gas Projects

This report was originally published before March 31, 2014, when Booz & Company became Strategy&, part of the PwC network of firms. For more information visit

Contact Information Dallas John Corrigan Principal +1-214-746-6500 [email protected] Houston Andrew Steinhubl Partner +1-713-650-4183 [email protected] Mark Uffhausen Senior Associate +1-713-650-4119 [email protected] New York Justin Pettit Partner +1-212-551-6309 [email protected]

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Despite the recent downturn in drilling and production, unconventional gas development projects in North America have surged during the past 10 years. To manage the risks associated with these activities, many companies employed a variety of hedging programs. Yet, although these hedging initiatives were intended to maintain capital stability in longterm projects, many upstream companies have felt compelled to curtail their capital programs in the face of the collapse in energy commodity prices. The problem is that the programs were generally designed to manage earnings by hedging large percentages of current production. While this strategy locks in the cash flow and supports the required return for existing production, it typically does not sufficiently underpin the cash flow needed to justify continued drilling if gas prices fall. And this is precisely what happened recently. A more effective alternative for these companies would have been to implement a hedging program directed at the needs of the capital program and not at the underlying commodity that would later be produced. Such hedging of targeted risks in capital projects can reduce margin volatility of project returns and help provide stability in volatile price and constrained capital environments.

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Unconventional gas production in the United States is expected to reach 13 trillion cubic feet (tcf) in 2030, up from about 8tcf in 2005 and 3tcf in 1990, primarily from an expansion in shale gas, coal-bed methane, and tight gas, according to the U.S. Energy Information Administration (EIA) (see Exhibit 1).

This rapid expansion in unconventional exploration and production activity in North America has been, at least until recently, the result of historically high energy commodity prices and improved drilling technologies. Unconventional gas projects become economically viable at US$5 to $6 per million

Exhibit 1 Unconventional Production Is a Growing Source of U.S. Gas Supply


Projections Onshore Unconventional

Natural Gas Production, 1990–2030 (trillion cubic feet)



Offshore Onshore Conventional Alaska







Source: U.S. Energy Information Administration


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cubic feet (Mcf), and prices have been above this threshold for the past three or four years. The upshot is that nine of the 12 largest U.S. gas fields are unconventional plays, with some big players—BP, Shell, and ConocoPhillips, among others— making large bets. Recent standout investments include Chesapeake Energy’s decision to increase its leasing and drilling capital budgets by as much as $675 million in 2008 and 2009 to secure acreage and accelerate drilling for unconventional gas

projects. And in June 2008, Talisman Energy earmarked $1.2 billion over 18 months for unconventional resource exploration. Even though gas prices tumbled recently, predicted gas growth through 2030 will likely still occur. We expect recent demand destruction related to the recession to be shortlived and gas demand to continue its robust growth over the long term due to both an expected economic rebound and federal legislation that

encourages the use of natural gas rather than more carbon-intensive fuels such as coal. As conventional natural gas production matures and declines, domestic unconventional gas or imported liquefied natural gas (LNG) will be needed to fill the shortfall in supply. At the current global market price of approximately $6 per million British thermal units (MBtu), it will be difficult for LNG to displace significant amounts of domestic unconventional gas.

We expect gas demand to continue its robust growth over the long term due to both an expected economic rebound and federal legislation that encourages the use of natural gas rather than more carbonintensive fuels such as coal.

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Unconventional projects are significantly larger, require more advanced tools, are more logistically complex, and involve greater highdensity drilling than conventional natural gas ventures. From an investment standpoint, conventional gas exploration holds more risk because these reservoirs are relatively small and difficult to locate; in the end, high volumes of gas may never be found. By contrast, after test wells prove the viability of a given area, unconventional resources can usually be predictably developed on a large scale—but over a long period of time, as much as three to five years.

As a result, unconventional projects require significant capital allocation decisions at a program level (as opposed to a well level). It is not uncommon to see investments of more than $1 billion for a single program. Indeed, Talisman has announced plans to spend $5.8 billion among five ventures. With such a significant up-front financial commitment and lead times that are typically quite long before companies enjoy any returns from an unconventional asset, it is very difficult to reverse course once a project gets off the ground. Few companies are willing to idle a project and leave capital in limbo or give up on a project and take the loss. To limit the risks inherent in unconventional projects, many energy companies hedge against future commodity prices, some more aggressively than others (see Exhibit 2). Projects that were a bit

better than breakeven at $7/MBtu and wildly profitable at $12/MBtu may no longer be viable at $5.50/ MBtu. Consequently, if hedging can smooth out the volatile stretches in energy prices, losses on projects can be minimized. However, as a means of mitigating investment losses in unconventional projects, hedging commodity price risk has had a decidedly mixed track record. Part of the reason is that much of this effort has been geared toward protecting particular risks that could affect balance sheets or covering debt obligations by minimizing the damage of short-term volatility in commodity costs. With that as the focus, investment activity in unconventionals fluctuates as spot prices rise and fall. Companies frequently get caught in the dynamic of overinvesting in unconventionals when the spot price is high and

Gas Production Hedging Trends

Exhibit 2 Gas Production Hedging Trends
2008, 2009 INDEPENDENT PRODUCERS 120% 2008 Hedged Gas Production 2009 Hedged Gas Production Year Forward P/E Multiple 64% 60 44% 40 20 9% 0 Anadarko AGGRESSIVE Anadarko Devon EnCana 0% Devon 0% EnCana 0% Cabot NOMINAL Cabot Chesapeake Pioneer Petrohawk Chesapeake 3% Pioneer 1% Petrohawk 50% 44% 42% 20 Forward P/E (1Y)

120 100 % Production Hedged 80



32% 16% 5% Apache LIMITED Apache Nexen Suncor Nexen 14% 15% 0% 0% Suncor



Source: Booz & Company


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underinvesting when it’s low. Some companies are retreating from their unconventional programs because of falling gas prices (see Exhibit 3). But because unconventional projects are generally long-term with a great likelihood of success, they should be structured financially around the future price for natural gas, not the spot price. A wider hedging program, covering more potential areas of risk for the company, can help break the misguided cycle that most companies find themselves in and give energy firms sufficient confidence to adhere to investment plans despite near-term price volatility.

There are four hedging approaches that should be considered in tandem and separately: basic project hedging for major projects, hedging to protect capital programs, hedging to protect financial covenants, and hedging to reduce volatility of corporate performance (see Exhibit 4). The four approaches require hedging an increasing amount of aggregate production as you move from the project level to the corporate level. Such a holistic approach to hedging is particularly critical today, when investors are apt to judge energy companies more by their ability to

economically develop plays, especially unconventional resources, than by current earnings. By hedging in this way, companies can reduce program cash-flow volatility earlier in the development cycle and stay on track to achieve projected returns. And by establishing a track record of commercial program success, gas companies can benefit from lower costs of capital, fewer stranded or delayed investments, and ultimately higher valuations.

Corp. Hedge •Manage earnings volatility through hedging production forward for entire corporate portfolio •Take market positions to avoid down cycles

Corp. Hedge

•H edge production sufficient to maintain cash Exhibit 3 flow above credit rating requirements Some Companies Are Lowering Unconventional Gas Investments Covenant Hedging •Protect against large moves down
NORTH AMERICAN UPSTREAM COMPANIES Chesapeake EnCana Nexen Petro-Canada Suncor Corp. Hedge 2009 CAPITAL EXPENDITURE REDUCTIONS $3 billion

� �

Mana produ


Capital Program Hedging

$1.3 billion $400 million $2–$3 billion $3 billion

•H edge production to preserve sufficient cash flow to support capital programs

Covenant Hedging

Capital Program Hedging

Source: Booz & Company

Project Hedging

•H edge project specific production and/or input costs to support project economics

Project Hedging

Exhibit 4 Four Primary Unconventional Gas Hedging Strategies
Corporate Performance Hedging Financial Covenant Hedging

- Manage earnings volatility by hedging production for entire corporate portfolio - Take market positions to avoid down cycles - Hedge production to maintain sufficient cash flow above credit rating requirements - Protect against large moves down

Capital Program Hedging

- Hedge production to preserve sufficient cash flow to support capital programs

Project Hedging

- Hedge project-specific production and/or input costs to support project economics

Note: Hedges can result in lower weighted average cost of capital (WACC) and thereby increase overall net present value (NPV), but the impact on corporate valuations is difficult to discern. Source: Booz & Company

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Corporate and financial hedging (the top two tiers in Exhibit 4) incorporate the activities of companies that hedge to manage overall corporate performance. Companies wishing to avoid the cyclicality of the industry and its impact on their investment programs may decide to hedge existing production to avoid profit losses when the project is completed and ensure a sufficient level of cash flow to support approved capital spend. This spend may consist entirely of planned expenditures or be limited to committed capital levels in an effort to avoid cancellation penalties or reputation risks with vendors. More financially aggressive companies—those that use a

higher leverage ratio to finance unconventional programs—may use hedging to maintain debt/credit requirements and high credit ratings. The goal is to ensure sufficient cash flow to satisfy debt service ratios. In today’s tight credit market and highly volatile energy price environment, hedges that ensure access to funding and reduce the requirements for tapping expensive alternative credit mechanisms—letters of credit, prepay agreements, deposits, etc.—can provide an effective means of managing overall debt costs, while paving the way for a track record of successful unconventional program development. Frequently, companies will elect to hedge a percentage of their production to reduce cash-flow volatility. This practice is typically driven by management’s view of the short- to medium-term price trends. In downward-trending markets, companies may lock in future production prices rather than current spot prices.

Traditionally, investor reactions to production volume hedging programs have been mixed. Studies have shown that because investors can hedge commodity price exposure themselves, they do not ascribe any meaningful incremental value to upstream companies that remain exposed to market prices. Instead, investors are paying premiums for companies that have demonstrated their ability to discover reserves and develop those assets in a costeffective manner. While hedging production does not ensure project success, managing project-specific risks in a more comprehensive way to deliver predictable cash flows from increasingly large and risky projects can have real value. The value comes from managing risks that investors could not easily manage themselves and from tying hedging activities directly to the risk profile of a project, as opposed to using hedges to manage performance.


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As oil and gas companies take on larger development projects, prudence leads management to consider project-level hedging (the bottom two tiers in Exhibit 4), especially in cases where project debt represents a substantial portion of the company’s total debt exposure. Managing the commercial risks associated with large capital programs involves focusing on risks to both revenue and cost. On the revenue side, managing price risk associated with gas production revenues can be done in a variety of ways, including

long-term contracts and financial instruments such as futures, swaps, and derivatives. This does not mean locking in commodity prices for the life of the asset, as in traditional corporate hedging strategies, but rather managing program-specific cash flows by establishing price floors or commodity hedges to reflect the changing risk profile of a particular project (see Exhibit 5).

On the cost side, companies can hedge underlying commodities through sourcing strategies, including prepay or trigger contracts, or they can hedge more indirectly using commodity markets as possible hedging mechanisms (e.g., using the steel contract on the London Metal Exchange to hedge oil country tubular goods (OCTG) costs.

Regardless of the methodology, two As a project’s life cycle progresses and key principles must be addressed associated risks decrease, companies when deciding what risks to manage will reduce the amount of risk they and how to manage them: hedge away in favor of allocating their capital to what they do best: • The hedge must focus on the developing assets. The increased project cash flow. FROM granularity and flexibility in the POWERPOINT FILE BELOW approach allows for hedging • The hedge should reflect the risk 100 away project-specific risk, thereby lowering of the project. As the riskiness of total hedging expenses while still the project decreases, so should 80 ensuring project economic viability associated risk management over the planned horizon. activities, as capital can be more optimally deployed.




Exhibit 5 Corporate and Project Hedging Strategies
100% Project Floor for IRR Corporate Hedging (high spot price)

80 % of Production Hedged

Corporate Hedging (low spot price)



20 Project Hedging 0 5 Projected Average Natural Gas Price over Project Horizon ($/MBtu) 10

Source: Booz & Company

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A company can create additional value by taking a dynamic rather than static approach to managing its project-based hedging strategy. Static hedging involves static positions to fix all or a portion of the expected commodity price to gain cost or revenue assurance. This is a simple model where the value of the hedge is determined largely by the market conditions in effect when the hedge is placed. This “one-time” approach often leads to management discussions about the right time to hedge or outright speculation through trying to pick tops and bottoms in the market. More sophisticated risk-based approaches utilize active management to minimize the cost and exposure of the hedging program. In this approach, the right time to hedge is

when the exposure is created. The hedge can then be lifted or modified as market conditions evolve. For example, when a project is initiated, the project price requirements are at or near current levels. This requires a large percentage of the expected volume to be hedged. If the price begins to rise, the hedges can be lifted and reestablished at the higher price. This would create a realization of losses in the short term, but the volume hedged can be reduced to reflect the smaller gap between the current market and the required price. In turn, as the size of the position decreases, credit requirements and mark-to-market impacts will be reduced. Understanding the cash-flow requirements and the cost of the risk and working capital allows optimization of the hedge over time.


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Designing a hedging strategy requires direct leadership by the executive team, especially the CFO. The hedging program must be well defined in terms of objectives, constraints, requirements, and governance. Any hedging program of significant size will need to be explained to investors. Further, there are a host of issues to be addressed by the strategy, including position size, correlations between cost and product prices (revenue), timing of cash flows, valueat-risk measures and caps, liquidity availability, cost, and potential mark-to-market impacts on earnings, among others. These elements must be matched to the goals for reducing project risk and be tempered accordingly.

Recent events have reduced available liquidity and increased volatility for exploration and production companies, adding significantly to their risk. This creates a more challenging environment for energy companies looking to develop robust hedging programs. Detailed cost–benefit analyses must be done to ensure that the hedging program both minimizes risk and is cost effective. Measures such as risk-adjusted rates of return are useful in these assessments. Once the hedging strategy has been developed and documented, execution and management can be turned over to commercial and risk management groups. However, the CFO will need to stay actively engaged to ensure proper execution and to provide a well-informed discussion of the program and its performance with investors.

About the Authors Andy Steinhubl is a Booz & Company partner working in Houston. He leads the global upstream oil and gas practice and has extensive experience assisting energy and energy services clients on issues including operations improvement, restructuring, organization design, and strategic and M&A opportunities. Justin Pettit is a Booz & Company partner working in New York. He specializes in shareholder value and corporate finance and is the author of Strategic Corporate Finance: Applications in Valuation and Capital Structure (Wiley, 2007) John Corrigan is a principal with Booz & Company in Dallas. He specializes in finance and trading within the energy sector. Mark Uffhausen is a senior associate with Booz & Company in Houston. He specializes in operations and risk management for the energy industry.

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