Friday, January 21, 2011

Chesapeake Energy's Derivatives Strategy

Aubrey McClendon, Chesapeake Energy's CEO, made news this week for an audacious move to juice Chesapeake's net income.

His bet on natural gas over the last few years turned bad, causing him personal losses on margined positions. Now, with gas prices looking soft for the near term, he's moving the firm into oil drilling. Sensing weakness, activist investor Carl Icahn has bought into Chesapeake.

Meanwhile, McClendon has Chesapeake aggressively hedging natural gas prices forward, with some positions allegedly not expiring until 2020.

Some analysts and fellow traders argue that Chesapeake is playing with fire. The company has already bet on gas prices as far into the future as 2020—a date so far ahead, some skeptics say, that the markets are too tough to pinpoint. CNBC reporter Kate Kelly wrote a piece yesterday which noted,

“I don’t really like the idea of selling out call options on gas prices and oil prices—mostly gas prices for the long-dated options—10 years out so that I can get more revenue today,” says Phil Weiss, a energy analyst who recently downgraded Chesapeake to a sell rating. “It’s just another way the company is mortgaging its future.”

McClendon counters that “90 percent” of Chesapeake’s hedging activity is focused on the “next eighteen months.” The trades dating to 2020, he said, are “basis hedges” intended to mitigate risk events in regional markets.

Other critics argue that Chesapeake’s hedges, while likely to succeed in the immediate future, will be tough to replicate longer-term.

“In 2011 they’re going to have material hedge gains,” said one energy trader whose company policy prevents him from speaking on the record, “but they’re not going to have that luxury going forward. Because if prices go up, they’re in great shape. But if prices stay depressed, they don’t have the flexibility they did in the past.

Chesapeake officials acknowledge that if gas prices rise far above the strike prices of the calls they sold—$5.84 and $6.19 for the next two years respectively—they could lose some money. But in that case, say officials, they’d be happy because produced gas could be sold at a higher price.

McClendon himself takes offense at the notion Chesapeake has become a hedge fund—a label Weiss and some traders have recently slapped on the company. “We don’t gamble. We don’t bet. We’re physically long gas,” McClendon says. “All we’re doing is mitigating risk.”

Unlike other gas and drillers, some of whom employ hundreds of dedicated traders, Chesapeake’s hedging team is a party of three: McClendon, newly-appointed chief financial officer Domenic Dell’Osso, and Jeffrey Mobley, the company’s senior vice president of investor relations. Before the team makes a move, its members say, their decision must be unanimous.”

Regardless of McClendon's remarks, doesn't this basically turn Chesapeake from a natural gas producer to a closed-ended natural gas options fund? Being naturally long due to their ostensibly main business doesn't make Chesapeake not a hedge fund. They could have just as easily bought options on production instead, and be just as long.

I'm not an energy sector analyst, but most pundits appearing on CNBC yesterday seemed to be shocked at McClendon's recent strategy moves.

I don't quite get how, if the firm has sold calls on current production, they can then claim that rising prices benefit them. Unless, of course, they didn't sell calls on much production capacity. It wouldn't seem that they can have it both ways.

From a larger perspective, McClendon can't both be able to profit more in the future if he's smoothing income now through the use of derivatives. Using derivatives either caps profits and/or losses, or is a one-way bet.

As I read McClendon's comments, and those attributed to the firm's executives, it's not clear which Chesapeake has really done. Which ought to give investors pause.

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