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Five Thousand Over Libor
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Energy trader with 11 years of experience in Natural Gas and Interest Rate markets. Manage a small trading organization, in the $25-50 million asset range, responsible for both consumption/production hedging and proprietary strategies.
  • Chesapeake’s Dry Gas Hedging is Now One Giant Short Put on Gas Prices 0 comments
    Nov 4, 2011 2:57 PM | about stocks: CHK

    So, let’s see if we’re reading this correctly, from CHK's Q3 release...

    “At November 3, 2011, the company does not have any open natural gas swaps in place.”

    Followed with...

    “The company currently has the following natural gas written call options in place for 2011 through 2020:” where they detail 16% and 40% of expected production sold in call volumes for 2012 and 2013, respectively. 

    Anyone with a sophomoric understanding of option trading knows that holding underlier length against short calls nets into a short put. 

    By selling calls against production, you rent out your upside for a one-off rent payment and maintain 100% of your downside price risk.  The former not nearly as worrisome as the latter, given their average strike in 2012 and 2013 of about $6.50. 

    This strategy works well in a steady-price environment, is less-than-pleasing in a steadily-rising price environment, and is damn near disastrous in a falling-price environment.  Generally speaking, a short-call production hedging strategy has all of the costs of swap-hedging (missing participation in price increases above the call strikes) with none of the benefits of swap-hedging (locking in prices in a falling environment) with the singular, one-off unique benefit of collecting premium.  

    Producers of anything, gas, oil, corn, wheat, lobster tails, do not effectively hedge by morphing their net position into a short-put structure.  Proper production-hedging seeks the transfer from company to market of downside pricing risks.  Net short put structures are actually best reserved for the hedging of consumption.

    The best that can happen here is gas prices rise right to CHK's strikes and McClendon gets to bark about “extracting value” via premium collection.  If gas prices fall, CHK has full exposure to that on their dry-gas production, which remained 69% of realized revenues for CHK in Q3.

    Perhaps dry-gas production is an afterthought for McClendon and company now; this ill-advised hedging structure certainly suggests it is.  That is, an afterthought, until it’s not, because if gas prices continue to fall – and we’re a warm-November and December away from that – it won’t be.  If dry-gas prices plunge, this could be the biggest bet CHK has ever made. 

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: I have never traded CHK, long or short and have no intentions to.
    Stocks: CHK
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