Tuesday, September 8, 2009

Hedging Leads to Short-Term Actions with Long-Term Consequences

Why would natural gas production companies continue to produce in the face of rapidly filling storage reserves and plunging pricing?  Recently I read an interesting article suggesting commodities price hedging creates a perverse incentive for gas producers to continue to produce in this terrible market environment.  Why would I shut down production if I’ve locked in prices at double the current market rate for X% of my gas?  Cool, right?  Maybe for them in the near term, but it’s not good for the industry as a whole, and it might have dire consequences for certain companies, even those currently over-producing.  There are short-term decisions being made today with significant long-term consequences, and there will be some victims.

Chesapeake CEO Aubrey McClendon famously said in the company's second quarter earnings call that his company wasn't going to take it on the chin for the team and curtail production if the other guys on the natgas team weren't going to join in.  Business among competitors is not a team sport (that would be collusion), but one can certainly see the attraction of a cartel like OPEC that can set targets and make production adjustments from the top.  It doesn’t work perfectly, but it helps moderate oil prices. Natural gas prices, by comparison, just swing around wildly. 

It is unfortunate to see the natural gas industry on one hand banding together to lobby Washington for better treatment, while on the other hand sowing the seeds of its own destruction.  Don’t get me wrong:  hedging done well is a very good business practice, but continuing to produce heavily in the current market environment is bad for the industry as a whole. 

Each company has its own issues and has to do what is best for it, especially those with loads of bank debt.  It is not their jobs to protect their brethren.  But if the natural gas industry wants to be taken seriously, it has to realize that the extreme price volatility in the industry over the past two years is not helpful in making its case to policy makers that gas is the stable fuel of the future.

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