Hedge Risk with Energy Stocks
Companies that produce oil and gas often sell these assets at peak prices. That's good news for investors.
In an investment environment characterized by fear and uncertainty, it can be comforting to own the stocks of companies that have tangible, scarce assets such as oil and natural gas. In this month's column, I'll explain the advantages of investing in companies that own substantial energy reserves.
Many veteran investors will buy good energy stocks during periods of low oil and gas prices because they know that a cold winter or an international crisis can send energy prices and energy-related stocks soaring.
Hedging strategies pay off
But it isn't only investors who can benefit from the swings in energy prices. Many oil and gas companies have learned how to lock in profits for future years by selling a good portion of their production in advance when prices are favorable.
Let me give you an example of how such "hedging" strategies work.
This winter, unseasonably cold weather and international tensions drove natural gas prices over $6 per thousand cubic feet, the highest price for gas in almost two years.
Taking advantage of this situation, a number of gas producers sold large portions of their 2003 and 2004 production in the "futures" market at high prices. The producers were willing to accept the "risk" that natural gas prices might spike even higher because they knew that by selling production in advance they were locking in excellent profits for themselves and for their shareholders.
Once the hedges were in place, the managers of these oil and gas companies had a good idea of how much money they'll have in 2003 and 2004 to fund new drilling projects and other capital spending. For these executives, selling production in advance at pre-set prices was a sound business practice.
It's a big advantage
Opportunities to use hedging strategies give energy companies an advantage that few other businesses possess. It's important that investors understand the benefits that hedging can bring because these strategies make energy-producing companies much more attractive as investments. Can you imagine a toy company trying to sell a new line of dolls to retailers years years before producing the dolls? The retailers would rightly scoff at such a suggestion.
The beauty of producing oil and gas is that there's always demand for these commodities. A company can choose a variety of ways to sell its production. It can sell at current prices, or in the futures market, or it can even choose to hold product back if it feels prices have gotten too low to enable the company to make a profit. And while there's some risk in these strategies, energy companies do enjoy a great deal of flexibility in setting the terms of their product sales.
But not all energy companies are created equal in terms of their suitability for investors. With many energy companies to choose from, look for those that don't carry much debt. The less debt that a company has to pay off, the more flexibility it has in deciding when and at what price to sell its production.
Also remember that huge energy companies such as ExxonMobil are obligated to supply product to their affiliates on a daily basis. Thus, their hedging activities are constrained when compared with the strategies that can be used by pure exploration and production companies.
The so-called E&P companies can literally choose to sell most or all of their production to the highest bidder. They can even sell the whole company to a bigger outfit if they so choose, usually at a price that makes their shareholders smile.
Optometric Management, Issue: June 2003