US Move On Speculation Resisted.

For oil and gas companies, a budding crack-down on US energy futures markets now comes at an awkward time. Producers are relying more than ever on the futures to hedge the risk that prices will fall, even as regulators take aim at energy traders to blunt the spikes which hit consumers last year. Recent earnings reports from a number of US companies - including El Paso Corp, XTO Energy and Chesapeake Energy Corp - showed a big boost from deals which locked in high prices for natural gas before that market sank to seven-year lows.

Those hedges in effect guarantee the income level the firms will receive on their output, bringing some stability to an inherently risky business. But producers need active speculators for this. Under long-term hedging plans, producers agree months or years ahead to sell oil and gas at a certain price. Those trades are only possible if there is a buyer, one who by definition is probably betting that prices will rise. The situation shows how efforts to protect consumers from soaring energy prices could have unintended consequences.

Chesapeake is among those warning that a poorly thought out rush to lock the doors to speculation could diminish the depth of the market, hinder the company's ability to secure the best price and deprive it of the "cash-flow certainty" which allows it to fund ambitious drilling programmes to bring on new supply.

In written testimony to the Commodity Futures Trading Commission (CFTC) on Aug. 5, the firm's Corporate Finance Manager Elliot Chambers argued: "Chesapeake has serious concerns regarding how position limits on energy futures and a more restrictive application of hedge exemptions would impact how we deploy our risk-management strategy". Had the company not been able to lock in gas sales to offset the risk of falling prices, he said, a $3.75bn investment leading to the 2008 discovery of prolific new gas supply in Louisiana "would not have been possible".

Hedges can hurt in bull markets, but they have paid off richly in recent months, as oil and gas prices fell from 2008's historic highs. El Paso VP for Investor Relations Bruce Connery said the firm's hedges contributed five cents of the 11 cents a share in second-quarter net income the company reported on Aug. 6. El Paso said hedges for 70% of the gas it expected to produce in the second half of 2009 will bring in $9.02/m BTUs. Gas futures on Aug. 4 settled at $3.541. At end-June, gas was down 71% from a year earlier.

XTO on Aug. 5 said it had booked a gas price of $7.08 in the second quarter thanks to hedging transactions. It had locked in $8.67/m BTUs on more than a quarter of the gas it expected to produce in 2010. XTO hedged its crude oil production, guaranteeing an average price of $107.14/b this past quarter. On Aug. 3, Chesapeake said it swung to a second-quarter profit thanks in part to its "successful hedging programme". Its $243m in net income included a gain of $597m on gas and oil hedges.

Critics were not moved. They argued the wave of investment in oil and gas futures had produced wild swings in prices unrelated to supply and demand. They noted that the volume of speculation dwarfed the inter-play between the physical producers and consumers.

Concerned about the market swings, the CFTC has been holding hearings to consider whether to place curbs on how energy futures are traded. Most of the talked-about curbs would restrict the activities of investors such as hedge funds which have no intention of making or taking delivery of the commodities they sell or buy. John Arnold, manager of $5bn hedge fund Centaurus Advisors and a major gas trader, on Aug. 5 told the CFTC the willingness of traders to take big risks was critical if producers were to invest in domestic energy supplies. If trading curbs were sharply tightened, he said, it would take many more speculators to make up the other side of transactions with big hedgers like Chesapeake. XTO spokeswoman Nicki Northcutt said "hedging is an integral part of our business strategy" and "we are keeping an eye on things" as regulatory changes were debated in Washington.

In a joint article out on July 27, French President Nicolas Sarkozy and British PM John Brown said paper oil's price spikes in 2007-08 dangerously defied the accepted rules of economics, while there was no serious interruption of physical supply. They wrote: "The risk now is that a new period of instability could undermine confidence just as we are pushing for [economic] recovery. Governments can no longer stand idle. Volatility damages both consumers and producers. Importing countries, especially in the developing world, find themselves committed to big subsidies to shield domestic consumers from potentially devastating price shifts".

They noted that world E&P investment was already down 20% over the past year, saying: "We are committed to the ongoing dialogue between producers and consumers [who] are closer now than at any time in the past 30 years to recognizing the huge common interest in giving clear and stable signals to long-term investment The Expert Group of the International Energy Forum should take the lead in establishing a common long-term view on what price range would be consistent with the fundamentals. These experts should also consider any measures that could be put in place to reduce volatility. And they should look again at whether trading activity is amplifying erratic price movements.

"We therefore call upon the International Organization of Securities Regulators to consider improving transparency and supervision of the oil futures markets in order to reduce damaging speculation. This would serve the interests of orderly and adequate investment in future supplies, since volatility and opacity are the enemies of growth. Climate change is also altering government attitudes to energy.

"The world's economy is still reliant on secure supplies of oil at prices that are not so high as to destroy the prospects of economic growth, but not so low as to lead to a slump in investment, as happened in the 1990s. It is a thorny issue, but complex markets need not be volatile or damaging to the wider global economy. We are convinced that producers and consumers alike would benefit from greater transparency, greater stability and greater consensus on the market fundamentals. After two years of destructive price volatility, the time has come for both sides to work together to build on our common interest".

Print Get the Mag Weekly Updates