By James A. Gibbs

All businesses have problems and must deal with uncertainties.  Oil and natural gas companies are no exception.

Imagine the difficulty of preparing business plans and financial projections for a manufacturing company that must make commitments for years into the future, continue to finance ongoing business activities, but has little or no control of the prices of products sold. Oil and natural gas companies confront this problem daily.

Whatever their core activities: exploration, production, refining or marketing, they must adjust and adapt to stay in business while dealing with a multitude of uncertainties that include competition, governmental interventions, and prices that can fluctuate not by percentages but by multiples of the price.  They are required to make assumptions about future market conditions and educated guesses about the prices they will receive when their produced oil and natural gas finally reach the market.  If they’re right, they make a profit and stay in business. If they’re wrong, they lose capital and may ultimately have to board up their doors and disappear from view.

Prior to 1972, fluctuations in oil and natural gas prices caused few problems.  From the 1930s to the 1970’s the price of crude oil remained remarkably stable, at about $3.00 per barrel.  Natural gas, where a market existed, sold for less than 22 cents per thousand cubic feet.  Much gas was sold for less than a dime, or simply flared or vented into the atmosphere. The big issue in those days was not instability, but simply low prices. 

The Arab oil embargo of the early 1970s demonstrated that OPEC countries and the cooperating non-OPEC oil-exporting countries had assumed control of the markets and could largely determine prices.  The price of oil rose throughout the decade, but was often buffeted by international politics, regional conflicts, and veiled or inaccurate reserves and production data.  Financial planning, forecasting and valuations in oil and gas companies became chaotic.

As a result, in 1982, the New York Mercantile Exchange (NYMEX) began trading futures contracts for the delivery of crude oil.  In late 1990 trading of contracts for future delivery of natural gas was initiated.  For the first time, oil and gas producers could “lock in” the price they would receive for products to be delivered at some future time (“selling forward”).  Major consumers of oil, such as airlines and trucking companies, could “lock in” the prices they would pay for products they would need later.  This allows both producers and consumers to lessen their volatility and risk. Growth of the futures markets greatly increased price transparency and stability, and facilitated planners’ ability to present logical and believable forecasts. Risk was mitigated between producers and consumers or transferred to speculators.

Beginning in 1990 during the first Gulf War, Five States began utilizing hedges.  In 2003, Five States made significant sales in the futures markets to reduce risk, help manage cash flow and protect profits. Our goals were twofold.  We wanted to insure that investors would receive satisfactory returns, and that Five States could continue to anticipate sufficient cash flow from our legacy oil properties in west Texas and elsewhere to sustain our operational viability far into the future. 

We accomplished this by maintaining a hedged position for approximately 50 percent of our future oil and natural gas. The result has been that when market prices exceeded the future contract price, we did not participate in the increased revenue of the portion of our production that sold at the wellhead above the contract price.  Conversely, when market prices are below the contract price, we received cash from the counterparty to cover the difference. 

Thus, since 2003, returns to Five States investors have been buffered by our hedged positions, both on the high and the low sides of our contracts.  Meanwhile, we all have been protected from the potential of catastrophic losses in the event oil prices had dropped into the teens or below and remained for a sustained period of time.

The futures markets provide a wide array of strategies that can be utilized for various market conditions and company strategies.  We routinely consult with experts to advise us on our hedge positions.  We’re not in the business of predicting future market prices or directions, so our goal is to utilize the futures markets to optimize our multiple objectives of income stability, solid net revenue, and risk abatement.