Hedging pricing-explained

The natural-gas industry is growing on borrowed time.

A surge in new natural-gas supplies available through shale-gas drilling has caused sustained downward pressure on prices in North America over the last two years. Producers have continued to increase production despite falling prices in large part because of financial hedges put in place when the market was stronger.

But those hedges will start running out next year, setting up a potential rebalancing of an oversupplied market.

In hedging, producers buy and sell contracts in the futures market to lock in a guaranteed price for their gas. But the downward movement in prices has lowered forward prices in the futures market, so producers can no longer lock in the high prices that have been a key source of funding for new drilling.

"You're going to see a spending slowdown, there's no doubt about it," said Mark Gilman, an analyst with The Benchmark Co. "That's ultimately going to contribute to an elimination of growth in North American production and prices that will ultimately gravitate up toward what would be considered an equilibrium level," he said. If that scenario plays out, it would likely take one to two years before gas prices would stabilize near $6 again, he added.

Canada's Encana, North America's second-largest gas producer by volume after Exxon Mobil, has said producers need prices in the range of $6 to $7 per thousand British thermal units this year to get an adequate return on capital and keep drilling new production. Spot prices in some markets were down to nearly $3/MMbtu recently, and two-year forward futures prices were trading near $5/MMBtu.

Encana had nearly half of its production hedged at above $6/MMbtu this year, but that level will fall to less than a third of production next year and even less than that in 2012.

The company hasn't yet backed down from its aggressive growth plan to double production within five years, but it issued a warning last month that its ability to grow may be constrained as its hedges expire and prices remain low.

Encana is a bellwether for the industry because it is a large producer with nearly all of its production in natural gas, and it maintains a strong hedging program. Many other producers will have even less production hedged going into next year, and less cash flow available to fund future growth.

Analysts at Morgan Stanley said in a research note last month that of the 26 large natural-gas producers they cover, about 43% of total production was hedged in 2010, but that would diminish to only 22% of production next year.

Tim Wall, president of the Canada division of Houston-based Apache, said "forward hedging has gotten tougher and the hedges have gotten quite a bit lower."

Apache had 41% of its North American natural-gas production hedged this year, according to its financial reports filed with the Securities and Exchange Commission, but didn't disclose its hedging level going into 2011.

"I would think there's got to be a return to reality in pricing," Wall said. "At this level of gas prices, it's got to start to affect the level of activity that all of us are doing in North America."

Wall said Apache hasn't cut back its growth plans yet, but it is looking at gas projects with higher rates of return, such as liquids-rich wells that yield petroleum as well as natural gas. Such wells boost profitability since crude-oil prices are much higher than gas. He also said Apache Canada is looking at shifting more capital toward oil projects in western Canada.

"We are very rate-of-return driven, so if we can make a gas project work at these prices, then we'll do it--but there are a lot of projects that will struggle at the current gas price," he said.

Encana says its strategy is to outlast competitors and continue growing in conditions where prices continue to be depressed.

"Over time, those that are not in as strong a hedge position and are living on the spot market would be expected to respond to the lower prices promptly. And over time, production would fall and prices would recover," Encana spokesman Alan Boras said.

How long a production pullback would last is still up for debate. It could be short-lived, said Phil Skolnick, an analyst with Canaccord Genuity.

"We could be sitting [at this price level] again next year," he said.


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