Chesapeake Energy's 'Offensive' Hedging Strategy

Chesapeake Energy, one of the country’s largest gas producers, boasts that its “offensive” hedging strategies have created more than $5 billion in gains in the last decade. But as it piles on longer-dated bets on gas prices, juicing short-term cash supplies and potentially curbing future profits from rising prices, some analysts and investors have grown concerned.

During the prior three quarters, through June 30, Chesapeake sold more than 70,000 long-dated call options in a bet that natural-gas prices would remain below about $8 between the years 2013 and 2020, according to company filings. During the same period, natural gas prices sank from just under $5 to the current levels of about $3.90 after briefly rallying to about $6 in January.

The Oklahoma City based Chesapeake, run by chairman and CEO Aubrey McClendon, is one of the most active hedgers in the oil and gas business. Commodities traders say that in recent months, it has also been perhaps the most active seller of long-dated gas calls, doing business with almost any firm that’s willing to bet that gas won’t rise above about $8 in the coming years. Citing the difficulty of predicting future prices, many oil and gas companies limit their hedging activities to a much shorter time frame of one or two years into the future, analysts say.

Chesapeake's rationale is simple: if gas prices remain below $8, it keeps the price the options sold for and never pays additional money to its counterparty. If gas prices soar past the $8 mark, it must pay the difference to its counterparties, but at the same time, it will benefit from the sale of more expensive gas to the broader market.

Because Chesapeake doesn’t break out what it pockets from the sale of options, how much it has made in premiums is impossible to glean. But some commodities traders and analysts believe the call sales have made a substantial contribution to its cash flows in recent quarters – and that, given the thinness of the market for extremely long-dated calls, the income from options premiums can’t possibly be sustained for long. (During the second quarter of this year, Chesapeake reported net income of $235 million and revenue of $2 billion.)

“Chesapeake needs more cash to support its activity than its operations can generate, despite management’s contention that the company has ample liquidity,” wrote Philip Weiss, energy-company analyst for Argus Research, in a recent note. He added: “We do not believe one can reliably forecast how high (or low) commodity prices…may be over the next three to ten years.”

Jeff Mobley, Chesapeake’s head of investor relations, doesn’t dispute that the company has benefited from the cash the call sales have contributed. He notes that his is a capital-intensive business and that “what we’re trying to do is manage our revenue stream and enhance our profitability.” Chesapeake’s hedging program has been highly successful during the last several years, Mobley adds, and if anything, the company would like to hedge more.

During the last three quarters, Chesapeake increased its sales of long-dated natural-gas calls from less than 19,000 in September of 2009 to the current 90,000, with average strike prices of $8.08. Its counterparties on the trades included Goldman Sachs, Morgan Stanley, and Barclays, among others.

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