Anadarko Petroleum (NYSE:APC) has benefited from the recovery of natural gas prices in the previous quarters. In order to cut down the risk associated with the fluctuations in the price of natural gas, mainly in case of a sudden drop, the company has a hedging strategy in place. Is Anadarko Petroleum's current hedging policy on natural gas prices reducing this risk?
Even though the price of natural gas passed the $6 mark at one point in the first quarter, this doesn't mean the company realized price reached this level. Anadarko Petroleum's realized price of natural gas was at $5.01. In comparison, Chesapeake Energy (NYSE:CHK) recorded a realized price of natural gas at only $3.27. The average daily price of natural gas reached $4.7 during the first quarter. One of the reasons Chesapeake Energy and Anadarko Petroleum had different realized prices is their hedging strategies.
Three way collar
Energy companies tend to purchase options and swaps, in order to bring down the risk related to the movements in the price of natural gas. For that end, Chesapeake Energy and Anadarko Petroleum use a hedge named a three way collar, in which they purchase a put option, sell a call option and also sell a put option. This type of hedging gives these companies a ceiling price and a floor price. A ceiling price means there is a cap for the realized price of natural gas. A floor price means the company hedges against a potential drop in the price of natural gas. For Anadarko Petroleum this ceiling is $5.01 and the floor is $3.75. But the company also sold another put option with a much lower floor at $2.75. This option means if natural gas prices plunge below $2.75, Anadarko Petroleum has to start paying for this option.
Chesapeake Energy's ceiling price is much lower at $4.38. Moreover, the company hedged nearly 68% of its total natural gas operations. Conversely, Anadarko Petroleum hedged only 20% of its total natural gas quota. Since Anadarko Petroleum hedges a smaller portion of its production and its ceiling price was much higher, the company's hedging plan only reduced its revenue by $92 million -- less than 2% of its revenue from production. This is among the reasons why Anadarko Petroleum recorded a much higher realized price of natural gas than Chesapeake Energy.
The three-way collar hedging plan is a way to reduce the cost of hedging by selling a put option at a very low price. This puts the company at a higher risk in case of a crash in the natural gas market. Could this scenario occur? Recall that back in the winter of 2012 the price of natural gas fell to $2. Therefore, even though this scenario isn't likely, it's possible. In such a case, the company will not only pay for its derivatives loss, it will also reach much lower revenue from its natural gas operations -- i.e. it will lose on both fronts. For Anadarko Petroleum, unlike Chesapeake Energy, the added risk is smaller because the former hedged a smaller amount of its quota.
Anadarko Petroleum has other hedging plans, including a swap contract, in which the price is set at $4.26. This hedge also accounts for roughly 20% of the company's total quota. This type of hedge doesn't allow Anadarko Petroleum to benefit from the rise in natural gas prices above $4.26. But this strategy reduces the company's risk from the fluctuations in natural gas prices and doesn't add additional risk like the three way collar does.
Anadarko Petroleum is taking unnecessary risk by using the three way collar strategy on its natural gas operations. Investors who seek to purchase this company's stock should take into account this added risk, the limitation the company has when natural gas prices rally, and the potential rise in losses when prices tumble.
Lior Cohen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.