Crude Oil ( ) Brent Crude ( ) Natural Gas ( ) S&P 500 ( ) PHLX Oil ( )

Commodity prices are influenced by several factors, including short-term catalysts and long term stimulus. Supply and demand often dictates short term prices, while factors such as future demand expectations and production decisions by the Organization of the Petroleum Exporting Countries (OPEC) can affect prices over the longer term. Supply and demand in the world oil markets are balanced through responses to price movements, with considerable complexity in the evolution of underlying supply and demand expectations.

Steve Hargreaves of CNN writes: “There’s an old adage in the oil industry: The best cure for high prices is high prices. Soaring prices lead to new investment, bringing new supplies to market. And that’s exactly what’s been happening since crude prices went off to the races nearly a decade ago.”

8According to the US Energy Information Administration, average prices for West Texas Intermediate crude, natural gas, western coal and electricity were higher in 2013 than in 2012. On the other hand, 2013 prices for North Sea Brent crude, various petroleum products and eastern coal finished below 2012’s average. Prices for major crude oil benchmarks and petroleum products ended 2013 mostly flat or down. The Bloomberg consensus estimate for WTI in 2014 is $95.50/Bbl as of January 24.

Crude prices were heavily influenced by several catalysts in 2013, including the initial supply disruptions in Libya in July, the uncertainty of military conflict in Syria in the last half of August, and the Iran trade restrictions striking an agreement in November. However, fall maintenance season in the United States pushed WTI inventories to near record highs, and as geopolitical issues subsided, crude prices declined. Heating oil prices rose this year because of strong global demand for distillate fuel and inventories near five-year lows. Gasoline prices, however, declined as a result of the high refinery runs needed to satisfy demand for heating oil and diesel fuel.

7U.S. natural gas prices ended higher in 2013 as cold weather across much of the country drove prices well above $4 per million British thermal units ($/MMBtu) in both the physical and financial markets. As a result, natural gas prices were 50 cents to $1/MMBtu above their level at the start of the year. The cold weather in December had significant effects on demand, supply, and prices across the country. According to the EIA, cold weather led to a net withdrawal of 287 billion cubic feet (Bcf) for the week ending Friday, January 10. This was the largest storage withdrawal since recordkeeping began in 1994.

Following a downturn at the beginning of 2012, the price of natural gas has risen for the last year and a half to reach $4.407 per MMBtu at the end of 2013.  The Bloomberg consensus estimate for Natural Gas in 2014 is $4.00/MMBtu as of January 24. On the same day, near-month natural gas futures hit $5.182 per MMBtu – the highest level seen since June 15, 2010.

Global End User Prices

Natural gas is consumed all over the world. This form of energy is supplied under a multitude of contract or tariff conditions which link the prices to the quantity delivered, the continuity of the supply, load factors and the pattern of use. The contracts or tariffs may also include a fixed charge component. The price of U.S. natural gas, due to its shale boom, has remained relatively stable or even declined over the last nine years. The prices in other countries have climbed higher – some rather dramatically. Outside factors such as political motivations, environmental sensitivity, transportation logistics, or taxes and tariffs can lead to a considerable price jump.

Japan has seen a major surge in the price of natural gas starting in 2008, while most other countries have seen this price stabilize or decline over the same period. In 2013, Japan’s imports of liquefied natural gas (LNG) rose to another record as the country’s second complete shutdown of its nuclear stations since the Fukushima disaster in 2011 forced utilities to burn more fossil fuels to generate power.

Price Volatility

9“Volatility is a gauge of perceived risk in the marketplace,” said Phil Flynn, senior market analyst at the Price Futures Group in Chicago. “There is more uncertainty in the market as traders come back after the new year. Crude inventories are going to rise after the year-end destocking and we still have geopolitical risk.”

Price volatility can have either a positive or negative effect on profits based upon the direction the price moves. In a single shift in 2012, the price of WTI went from $109.77 per barrel to $77.69 per barrel, a 29.2% drop in a four month period. Dramatic price shifts can effectively tie a company to a particular position or can act as a catalyst to facilitate a beneficial move to a different area or property to generate better well economics. Companies who carry a higher debt load are tied to particular economics due to the need to generate profit to offset the debt. They lack the flexibility and capital to move into a new play or shift from oil to gas, or vice versa.

10The ability to maneuver quickly creates resiliency if the price of a commodity fluctuates. Companies will often try to gauge the future direction of price movement in order to lock in a guaranteed income through hedges. While the price fluctuations could lead to a gain or a loss, it does create a predictable revenue stream. Analysts’ consensus estimates are used as a barometer of where the prices may go in the coming years. Companies utilize these estimates in order to create their own estimates for future price movements.

Hedge Positions

A conventional hedge seeks to provide insurance against rapid price increases or decreases. Hedges allow a return regardless of which way the market actually moves. Locking in pricing and hedging for a good portion of your position ensures a profit regardless of the price movement. Since prices are under a contract, each trading session guarantees a winner in one direction but a loser in the other. However, in some industries (particularly with smaller-cap companies), a portion of the loaf is better than no slice at all.

We examined hedging positions at two companies.  Their hedging positions are representative of the way companies seek to lock in prices and profits to avoid major discrepancies from price fluctuations, and for financing their capital investment programs.

Range Resources

Range Resources Corporation is among the leading independent natural gas companies operating in the Marcellus Shale and horizontal Mississippian plays. A large portion of the Company’s drilling inventory consists of unconventional resource plays targeting shale and coal bed methane natural gas reservoirs.

6From Range Resources website: “The Company utilizes hedging as a risk-management tool, entering into hedging agreements to help ensure a predictable level of cash flow and earnings.  Our usual hedging strategy is based on implementing a combination of swaps and costless collars.  Collars ensure a minimum floor price, but allow the Company to benefit from price increases up to a predetermined ceiling price.”

According to Range Resources’ investor presentation, approximately 50% of projected production is hedged.  The hedging program allows the company to effectively plan ahead, accurately allocate capital expenditures and establish capital structure without being overly concerned about price volatility. As noted in the chart, Range aims to lock in prices as far as two years in advance. By establishing a price of $4.16/MMBtu on a 2015 hedge, Range is protected against down side risk if the price of natural gas were to fall.

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Energy XXI

3Energy XXI is an oil-focused company with assets in South Louisiana and on the Gulf of Mexico Shelf. The Company has more than 400,000 acres of leasehold and almost 7,000 square miles of 3D seismic data.

According to EXXI’s investor presentation, roughly 60% of its production is hedged for 2014, with the potential for more contracts to come into play as the year progresses.

One way to evaluate the effectiveness of hedges is to look at the realized price of both Energy XXI and Range Resources over the last several years. The realized price is net of hedging and a yearly average price that the company received for its production.

This chart shows both Energy XXI’s and Range Resources pricing.

Presentation12

Over the previous seven years, Energy XXI has benefitted from the hedging of natural gas prices by realizing a better price than the actual natural gas price for the majority of that period. Over the same time, the majority of hedges utilized for Crude Oil have underperformed the actual oil price. However in the last two years, Energy XXI has been able to capitalize on the hedging of oil and has realized a higher price per barrel than the actual.

Range Resources hasn’t performed quite as well as Energy XXI, but has been able to utilize natural gas hedges over the last four years to realize a better price for their production.

The volatility of the commodity market can be affected by many factors, including supply and demand, market expectations, geographic location and hedging positions. This creates an environment of speculation in an attempt to be on the right side of the movements, capturing more profit from an upswing and protecting profit against a downward movement. The only certainty moving forward is that market prices will continue to adjust to these various factors and the resulting volatility will keep companies and investors on their toes. 

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Important disclosures: The information provided herein is believed to be reliable; however, EnerCom, Inc. makes no representation or warranty as to its completeness or accuracy. EnerCom’s conclusions are based upon information gathered from sources deemed to be reliable. This note is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument of any company mentioned in this note. This note was prepared for general circulation and does not provide investment recommendations specific to individual investors. All readers of the note must make their own investment decisions based upon their specific investment objectives and financial situation utilizing their own financial advisors as they deem necessary. Investors should consider a company’s entire financial and operational structure in making any investment decisions. Past performance of any company discussed in this note should not be taken as an indication or guarantee of future results. EnerCom is a multi-disciplined management consulting services firm that regularly intends to seek business, or currently may be undertaking business, with companies covered on Oil & Gas 360®, and thereby seeks to receive compensation from these companies for its services. In addition, EnerCom, or its principals or employees, may have an economic interest in any of these companies. As a result, readers of EnerCom’s Oil & Gas 360® should be aware that the firm may have a conflict of interest that could affect the objectivity of this note. EnerCom, or its principals or employees, may have an economic interest in any of the companies covered in this report or on Oil & Gas 360®. As a result, readers of EnerCom’s reports or Oil & Gas 360® should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.