Chesapeake Energy (NYSE:CHK), the Oklahoma City-based energy producer, has made some major strategic changes over the past year. Under the leadership of new CEO Doug Lawler, the company is targeting higher oil production, while slashing costs and reducing leverage. It's also employing a more conservative hedging strategy than it did in previous years. Let's take a closer look at why this matters.
Why energy companies hedge
Energy exploration and production companies hedge their oil and gas production for a few main reasons. First, hedging allows an effective way of mitigating commodity price risk by locking in the future prices of oil or gas. Given the high degree of volatility in commodity prices, most companies choose to hedge a portion of their oil and gas production for at least the current year, and usually longer.
Second, hedging is often used to stabilize a company's cash flow in order to ensure it can cover its fixed operating expenses. In Chesapeake's case, this is crucial because of its tight financing situation. Indeed, one of the company's biggest priorities is balancing its capital expenditures with cash flow from operations, while also reducing financial risk and complexity.
Chesapeake's hedging strategy
To achieve this goal, Chesapeake is opportunistically hedging its expected oil and gas production through various derivative instruments, including swaps, options, swaptions, basis protection swaps, and collars. By doing so, the company can be much more certain about the prices it will receive for its production in the future, which provides much greater cash flow predictability.
Chesapeake has hedged about 79% of its remaining gas production for the year at an average price of $3.70 per Mcf, and about 94% of remaining oil production at an average price of $95.64 per barrel. It has also taken advantage of recent favorable conditions in the natural gas futures marketplace by hedging roughly 12% of expected 2014 natural gas production at $4.23 per Mcf and about 52% of estimated 2014 oil production at an average price of $93.79 per barrel.
Compare that to Chesapeake's hedging strategy just two years ago, which ended up being a dismal failure. In October of 2011, the company exited all its natural gas derivatives positions in anticipation of higher gas prices. But gas prices plunged in early 2012, dipping as low as $2 per Mcf in April. As a result, Chesapeake lost between $750 million and $900 million in late 2011 and early 2012, a Wall Street Journal analysis found.
Other companies' hedging strategies
Other gas producers also hedge their expected future production to mitigate commodity price volatility and lock in future cash flows. For instance, Ultra Petroleum (NASDAQOTH:UPLMQ) has hedged roughly 22% of its remaining forecasted gas production for the year at a weighted-average price of $3.75 per Mcf to ensure that it can fund its capital spending program for the year.
On the other hand, some energy companies take hedging to an entirely different level. Take LINN Energy (NASDAQ:LINE), for example, which has hedged 100% of its expected natural gas production through 2017 and 100% of its expected oil production through 2016. The company's incredibly conservative stance on hedging is mainly due to LINN's status as a publicly traded oil and gas limited liability company that pays a sizable distribution to investors. Hence, it requires a much greater level of price certainty in order to sustain its distribution payments.
The bottom line
Chesapeake's current hedging strategy is just one more sign that the company is serious about financial discipline as it works diligently to balance its capital spending with cash flow from operations. The company is also making solid progress in growing oil production, slashing production and overhead costs, and continuing its asset sale program.
If Chesapeake can continue to deliver the solid operational performance it has over the past few quarters, while simultaneously reducing its capital intensity and leverage, it should be able to unlock a whole lot more value for shareholders in the years to come.
Fool contributor Arjun Sreekumar owns shares of Chesapeake Energy and Ultra Petroleum. The Motley Fool recommends Ultra Petroleum. The Motley Fool owns shares of Ultra Petroleum and has the following options: long January 2014 $30 calls on Ultra Petroleum, long January 2014 $40 calls on Ultra Petroleum, and long January 2014 $50 calls on Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.