The fast development of shale gas has revolutionized the American natural gas market; shale gas production now represents more than 20% of the domestic consumption. Meanwhile, natural gas prices dropped: the NYMEX price now stagnates around $4/MMBtu from $12 in June 2008. How is it possible to ensure a fast-increasing and profitable production at such prices? Part of the answer is that producers were actually paid a much higher price, thanks to hedging strategies on commodity markets. But now, pessimistic market expectations make it harder and harder to benefit from this mechanism, putting an important share of this capital-intensive industry’s cash resources at risk.
In a context of high market uncertainty, with an increasing supply and stagnating prices, shale gas producers have been extensively using hedging as a way to mitigate their price risk and to ensure a profitable gas production. Whereas it is very unusual for international companies to do so, shale gas producers use price financial derivatives as part of their strategy; by using swap contracts, they are indeed able to fix the selling price of a share of their production to come.
The first reason why hedging has been used is that the development of shale gas was not lead by Supermajors but by independent and often specialized companies such as Chesapeake, XTO (acquired by Exxon Mobil in 2009), Anadarko, Devon, and EnCana. Supermajors bet on a global commodity price increase and are therefore seeking the highest oil price leverage possible, by investing on high risk/high reward projects: being exposed to commodity prices is a core element of their strategy. An international oil company’s objective is indeed to pay dividends to its shareholders thanks to high-return project; it is made possible by its strong balance sheet, which allows it to take risks that a smaller company would not dare to take. Independent shale gas producers have the opposite risk profile: these companies’ risk is highly concentrated as they rely on a unique exploitation technology, produce gas in a single or few countries, and sell their whole production in the same market. Hedging natural gas prices is therefore a way to mitigate operational and country risk, and to secure their profit to come.
Secondly, the industry is structurally capital-intensive and has some particularities compared with conventional gas exploitation. The market has experienced a “rush for acreages”, during which producers acquired quickly large concessions in order to secure the most promising acreages, despite limited knowledge of geological conditions, which required additional cash. The high need for cash combined with their price-sensitive nature explains the will to secure their selling price through hedging.
Finally, by nature, shale gas wells tend to have much steeper decline curves than conventional gas wells. As a consequence, profit must be made in a shorter period, and the price risk is more concentrated in the early months of production than for conventional gas.
Shale gas producers have more or less successfully implemented price hedging strategies for their production. The following graph shows the hedging gain or loss that has been made quarterly by the largest independent shale gas producers in the US, compared to the Henry Hub spot price. It is defined as the gain (loss) due to the price differential between the spot price and their actual selling price for their hedged production.
This chart shows a high variance in the exposure to spot prices among these companies. Unsurprisingly, hedging losses have been made during the 2008 peak of natural gas prices, and gains have been made since the beginning of the collapse of the Henry Hub in mid-2008. Indeed, when the Henry Hub rocketed in 2008, some of these companies had already hedged part of their future production at a lower price, because this sudden increase was unexpected. The opposite phenomenon happened in 2009 and 2010, and producers thus managed to hedge at much higher prices.
Companies do not restrict their hedging strategies to exchanges such as the NYMEX. They also use over-the-counter (OTC) transactions, which consist in trading financial instruments directly between two parties; it can be a way to achieve to lock higher prices than on the exchange. The following benchmark shows the NYMEX-related price at which shale gas producers have been able to sell their production, on a quarterly average basis. It is compared to the quarterly average of the Henry Hub spot price and to futures contracts: for a given quarter, the blue area indicates a range of futures contracts with a delivery due during the quarter.
The comparison between reported selling price and the Henry Hub spot price highlights the premium brought by hedging to the profit of these companies. Some of them are able to sell at a price more than 30% higher than the spot price, enhancing dramatically their wells’ rates of return. The comparison with the NYMEX futures contracts shows that most of the companies only hedge a small share of their production and therefore do not reach futures prices. In the other hand, Chesapeake and XTO achieve to sell at prices above the range of futures. The use of OTC transactions is one of the main explanations. The most striking example is the creation by Chesapeake of a multi-counterparty hedging facility with thirteen counterparties which provides it a hedging capacity of about four years of production. In addition, Chesapeake’s obligations are secured by its reserves, while the counterparties’ are secured by cash, providing new liquid assets for Chesapeake’s investments.
Shale gas producers have been widely using price hedging in order to secure their cash flows, and it has been a successful choice over time for these companies. Some of them have even developed their own trading infrastructure in order to optimize their hedging strategies. A recent study by Citi showed that in 2010, hedging gains represented on average 14% of top shale gas companies cash flows and up to 30 or 40% for some companies. Natural gas price hedging has indeed been a non negligible source of cash, and an accelerating factor for the development of shale gas. But given the widespread gloomy forecasts, due to the current gas glut and a still fast-increasing supply, hedging at high prices is logically becoming increasingly difficult for gas producers, and it does not provide the financial leverage it used to. The price differential between a futures contract with a delivery due in 12 months and the spot price has narrowed to below $0.5/MMBtu, far from the historical $1.5/MMBtu. Producers are now seeking new ways of improving their returns, such as focusing on oil-rich gas reservoirs; with a $107/bbl oil price, it remains a safe value, far from the worry about natural gas.
Pierre-Adrien Ludwig, Mines ParisTech