Friday, March 23, 2012

Hedging NGL Production

Recent report by Platts:

"Some producers are having difficulty hedging their rapidly expanding natural gas liquids production, as currently available financial products lack sufficient liquidity or product correlation. In essence, producers are still learning how best to hedge their liquids output, according to Michael Zenker, director at Barclays Capital. Some producers will lock in an NGL hedge as a percent of oil production, which results in a proxy hedge that may leave them vulnerable to situations when the prices of oil and liquids do not correlate." Also reported by Gas Business Briefing

My point of view:

The financial products priced at Mt. Belvieu, Texas (MTB) and Conway, Kansas (CWY), both do provide sufficient liquidity. MTB is better since there are more traders and more contracts exchanged daily (estimates placed at between 150 - 300 contracts per day).  CNW is less liquid (50 - 75 contracts per day). Depending on your company's thresholds, typically established by internal risk and credit groups, these volumes may not be liquid enough based on the standards used for buying/selling natural gas.  LESSON: Using financial instruments for NGL is not the same as natural gas... you need to recalibrate the liquidity thresholds based on the NGL marketplace and match back to your own NGL production profile.  This will require educating your risk and credit groups... good luck, some of them may still think NGL is text-shorthand for "not gonna lie".

In 2005, our team developed several regression models comparing historical pricing between Edmonton, Alberta, Canada (EDM), CWY and MTB.  EDM was the most illiquid.  In fact price discovery was outright non-existent, if it wasn't for our actual production that was being produced and sold out of Taylor, British Columbia, Canada (Younger Extraction Plant) and central Alberta. CWY was better, but still had issues. Some of them well published through the press and legal courts since there are fewer major players that act as traders out of this hub.  MTB remains the best NGL trading hub, based on the aggregation of supply and the large petrochemical industrial demand

That being said, simply executing hedges priced at MTB and CWY will still leave you open to other forms of risk, since your sales point may not be close to MTB or CWY.  Many producers contract to sell their natural gas and NGL at delivery points thousands of miles/kilometers upstream of MTB and CWY. As a result, producers are subject to basis risk, or the pricing differential between their sales point and the end market consumers of NGL. LESSON: To reduce basis risk, enter into NGL sales contracts that are priced off of MTB or CWY with a firm deduction that would approximate transportation, marketing and ancillary fees.  This will allow you to receive MTB- or CWY-based pricing for your production, and will enable you to hedge by using financial instruments priced at these locations... thereby reducing basis risk.

On another note, I am not necessarily a big proponent of hedging NGL.  The market for NGL has disconnected from natural gas prices (other than ethane, which is still highly correlated to natural gas).  The historical frac spread for NGL gapped out in 2006 and has not returned to long-term averages (1995 to 2004) since then, except for brief couple weeks in late 2008. However, if your company needs price certainty to support the quarterly earnings, met dividend commitments or show stability for bankers or credit rating agencies, using NGL hegdes to lock in frac spread or NGL margin, the above strategies will help... but be prepared... these instruments typically settle out of the money, since price certainty comes at a price.  Just like insurance.

Other sources: