Reference no: EM131670086

Question: CHESAPEAKE ENERGY HEDGES ITS WAY TO THE FUTURE

In many industries, prices tend to follow reasonably predictable patterns over time, such as rising in line with inflation or declining as a result of new technologies and greater production efficiencies. Commodities such as natural gas are a different beast altogether, with wide and often unpredictable swings. However, producers can't always adjust their ongoing operating expenses to match revenue, at least not with anywhere near the same rapidity at which prices fluctuate. For example, gas companies can spend millions or billions of dollars in exploration and leasing costs (to secure drilling rights from property owners) before production can even begin. If they then decide to limit output because prices are dropping, they can be left with an expensive asset that's generating little or no revenue. Because operating costs can't be cranked up or down to match revenues, an increasingly common financial strategy for producers is to even out the revenue stream through the use of commodities futures. By locking in prices months in advance to increase the predictability of their cash flows, companies are better able to manage major capital budgets and their overall operating budgets. At Oklahoma City's Chesapeake Energy, the nation's largest independent producer of natural gas, futures contracts are an integral part of the company's financial strategy. Of course, Chesapeake's corporate finance manager Elliot Chambers would probably be the first to tell you that even though hedging can reduce a company's risk exposure, it is not without risks.

Companies that guess incorrectly about future price shifts can pay dearly. For instance, in the second quarter of 2008, Chesapeake had paper losses of $3.4 billion on its hedging contracts because market prices had risen higher than the prices it had previously locked in those contracts. Such losses are known as paper losses (or unrealized losses) because they happen only "on paper" until the futures contract actually comes due. Let's say that in January, Chesapeake signs a futures contract to sell gas at $6 per thousand cubic feet in October. However, if market prices rise to $8 in June, the company has a paper loss at that point of $2 per unit. It hasn't actually lost the $2 in June because it doesn't have to settle the contract until October, so the loss is considered to have happened only "on paper." Interim paper losses might sound like they're not a problem because no money changes hands. After all, the market price in this example could settle back to $6 by October, in which case Chesapeake would essentially break even-or make money if the market price drops below $6 by October. However, the reason paper losses matter is that accounting regulations require companies to treat these losses as real in their ongoing financial statements. In other words, when Chesapeake had paper losses of $3.4 billion on its hedging contracts in the second quarter of 2008, those losses showed up in the quarterly income statement. And since the stock market pays very close attention to quarterly income statements, a company's stock can get hammered even though such losses are (as yet) still on paper. True to the wild nature of the natural gas market, halfway through the third quarter of 2008, Chesapeake's futures contracts had swung around in the positive direction, giving it a paper gain at one point of $4.7 billion. Like a paper loss, such a paper gain doesn't involve any money changing hands, but it must be accounted for in the financial statements. When the contracts come due, losses or gains become quite real.

If market prices at that point are higher than the price in the contract, Chesapeake suffers because it is forced to sell product at less than it could have gotten otherwise. Conversely, if market prices are lower than the contract price, the other party loses and Chesapeake wins, because the other party has to pay more than the market price. Clearly, hedging is not an exact science or a perfect remedy, but it does bring predictability to a company's cash flow and thereby allow it to plan the massive capital projects needed to bring new production online. Moreover, if a company does well over time, hedging can be a source of revenue. During one recent three-year period, for instance, Chesapeake increased its revenues by more than $2.4 billion through hedging. Because the uncertainties of hedging are lower than the uncertainties of not hedging, the company plans to keep using these contracts as a central component of its financial plan. By the way, anyone following the use of commodities futures in the natural gas market must wonder why gas prices swing up and down so unpredictably-and in ways that aren't always related to supply and demand. After watching the gyrations in energy prices over the past few years and the destruction that derivatives recently caused in the banking industry, government regulators now worry that the very same financial tools that producers use to protect themselves from violent price swings could be contributing to those swings in the first place.

The federal Commodity Futures Trading Commission contends that in the hands of speculators, commodities futures contracts are disrupting prices in ways that harm consumers and industrial energy users. The commission is considering placing restrictions on speculators trading commodities futures with no intent of buying or selling the actual commodities themselves. In response, hedgers such as Chesapeake say they can't run their businesses without the participation of speculators because they provide the financial predictability necessary to plan budgets in an inherently unstable industry. For instance, Chambers told the commission that without speculators, Chesapeake would never have been able to invest the $3.75 billion it took to discover and develop a major new source of natural gas in Louisiana. With the United States looking for ways to reduce its dependence on imported oil, the plentiful supply of domestic natural gas is playing an increasingly important role in national policy discussions. It could come down to a tug-of-war between the need to develop more domestic sources in the long term and the need to bring stability to end-user energy prices in the short term.30

1. If speculators are barred from investing in futures contracts, how will that change Chesapeake's
approach to financial management? (Assume that natural gas distributors and other major customers would still be able to engage in futures contracts from a commodity buyer's perspective.)

2. Why do you suppose accounting regulations require companies to report paper losses or gains from futures contracts in their fi nancial statements?

3. Should the government continue to allow speculation in natural gas futures as a way to keep developing domestic energy sources, even if it can be proven that speculation contributes to price volatility for producers and customers? Why or why not?