The risk of a collar hedge is that companies sacrifice additional profits if prices continue to rise beyond the ceiling set by the company’s call price. Gas prices have already risen beyond Apache’s call price of $5.26. But Plank points out that if he had hedged with a traditional forward swap at the time of the Occidental acquisition, Apache would be selling gas at $3.30, and losing $2.
“So if it goes to $7.25, we miss $2, but we are still getting $2 better than we anticipated, and our rate of return is still way better than we expected,” says Plank. “You can’t complain. You have to have that kind of psychology or you’ll never use this kind of strategy.” Of course, he notes, “Everybody has a different opinion with hedging.”
Indeed, Pogo Producing did not use collar hedges. Immediately after the company announced plans to acquire Noric for an Mcf price of about $1.40, says CFO James P. Ulm II, he purchased a floor of $4.25 per Mcf for April 2001 through March 2002, and a floor of $4 from April through December 2002.
“We used floors because it allowed us to lock in the economics and guarantee the cash-flow levels we wanted–and we kept all of the upside for investors,” says Ulm. Unlike the costless collar, however, that hedge cost $24 million on a total acquisition cost of $750 million. “We have used collars and fixed-price swaps in the past,” he says. “Those are all hedging tools at your disposal, and you pick the best tool. In this case, using floors was the best thing to do.”
Hedging is a relatively recent phenomenon in the gas market, adds Ulm, noting that the New York Mercantile Exchange first listed natural gas as a commodity in 1990. “There is a convergence of high commodity prices and a developing hedge market that has made companies more accustomed to hedging over the past five years,” he says.
SPOT DEFERRED CONTRACTS
Hedging has long been a strategy for other extractive commodities, such as gold, where sharp differences in price have always existed between reserves and finished products. “The price of metal in the ground is low relative to the price of refined metal–the difference is much more severe than it is in the oil and gas industry,” explains Jeffrey M. Christian, managing director of New Yorkbased metals commodities consultant CPM Group. “The major cost for oil and gas is exploration, whereas in metals it is extraction.”
Christian points to Toronto-based Barrick Gold Corp., which has been hedging for 15 years, as a leader in hedging strategies. “If the gold price moves against them, their hedge book becomes a tremendous financial asset,” he says. “They can go out and buy depreciated assets– reserves in the ground–with their appreciated asset: the hedge book.”
Barrick hedges about 25 percent of its gold reserves and a portion of its production. The company uses spot deferred contracts, explains CFO Jamie Sokalsky, which can be deferred for any period up to 15 years if prices rise. For example, although spot prices are currently around $270 per ounce, Barrick has locked in a price of $340 per ounce for this year and next. “But if the spot prices rise above those levels, we will sell at the higher price and defer these existing contracts at increasingly higher prices,” says Sokalsky. Barrick, he claims, has sold its gold at prices higher than the spot price for 52 consecutive quarters.