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Production hedging for commodity producers should be about enabling a company to fund its value-added activity, which is exploring, developing and exploiting assets. Lots of ink has been spilled about how Chesapeake Energy's (CHK) earnings per share fell in Q1 2007 (as compared to Q1 2006) due to mark-to-market hedge losses. I think these comments miss the point.

As a current CHK investor (both my clients and I own CHK), if management can find and bring to market an mcf of gas for $4-5 and sell it forward (hedge it) for $8-10/mcf, it would seem only prudent to do so for some percentage of their production to ensure they will have the cash flow to support further similarly-profitable development. Why should running a E&P (exploration & production) company be any different from running an oil refinery or an ethanol plant, where plant owners know exactly how much it costs to convert oil-to-gasoline (crack spread) or corn-to-ethanol (crush spread) and so long as the input commodity and the output commodity prices can be fixed beforehand, minimum budget targets can be met?

Furthermore, there's great optionality for CHK and other hedging producers. When natural gas prices fell last summer, CHK reduced gas production slightly, helping to support gas prices, and also closed some previous hedges, locking in gains. In the 1990's, when aluminum prices were below production costs, I believe Alcoa (AA) bought a boatload of aluminum futures prior to announcing a production cutback, making a fair bit of money on the trade, which helped to offset some of the operating losses.

I like to think of the mark-to-market balances, or value of the hedges, as a balance sheet item, which happens to rise/fall in value inversely with the commodity price. Typically, and correctly in my mind, the stock should react much more to the movements in gas prices, rather than the change in mark-to-market hedge value as the preponderance of company value is the gas in the ground.

Disclosure: Author has a long position in CHK

CHK 1-yr chart

CHK

Source: Chesapeake Energy: Value is the Gas in the Ground