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Both crude oil and natural gas prices have continued their bull market runs through most of 2004, leaving many oil and gas producer hedgers feeling like they've just run through the streets of Pamplona. But as the excitement ends and the gore of 2004 is washed away, the decision has to be made as to whether they'll come back for another adrenalin rush in 2005.

Many won't, and it won't be the first time that producers have retreated from hedging activity after material hedge losses have been incurred. History points to two blatant examples in 1985-86 and 1992-93. In both of these instances, North American energy producers had substantial hedge positions in place during significant market rallies, and many abandoned their hedging strategies right at the market peak. The price collapses that followed were characterized by some of the most underhedged producer portfolios since the advent of financial energy risk management in the mid-80s.

Ironically, most of the criticism directed at producer hedge programs during these periods by shareholders and investor analysts centered on the losses that were amassed during the run-up in prices - there was little criticism directed at the fact that these so-called hedge programs did not serve to protect investors when prices plummeted. Theoretically, producers could defend the initial hedge losses by arguing that the objective of the program was to mitigate the exposure to falling prices and not to make money on the hedges in isolation. However, investors should have been more aggressive with their criticism of these programs once it became clear that there was no consistency to the hedging activity and they were left without cash flow protection when it was needed most. And that could happen again in 2005.

While there have been no studies examining the cumulative gains or losses generated by North American oil and natural gas producer hedging programs since 1985, our experience would indicate that the producer community is in a material net loss position over this timeframe. There are a number of theories that one might use to explain the poor long-term performance of producer hedging activity, including the fact that we have experienced a long-term bull market in energy prices, and the argument that forward prices systematically appear to underestimate future spot prices. However, RiskAdvisory believes that the most significant reason is the mismanagement of the hedging activity itself. And this mismanagement is not a function of the headline-grabbing "rogue trader" phenomenon - the losses attributable to willful trading violations are minor compared to the cumulative losses incurred by the industry. The mismanagement has centered on the role of market views in the application of the hedging strategy and the resulting inconsistency of the risk management activity.

In many instances, the implementation of producer hedges is driven by the perception of the management team (and in some instances just the CEO) that prices are likely to fall. If this expectation does not exist, then hedges are not established. At first glance, this might appear reasonable - what producer would want to establish hedge positions if it thought prices were going to rise?

The problem is that in the liquid North American natural gas and crude oil markets, current forward market prices are set based on the consensus view of market participants. If everyone believed that future spot prices were going to be below today's forward price levels, then the forward prices would have already fallen to those expected levels. The market might be trading above a CEO's price expectation, but that means that there are many other market participants who are buying the commodity forward at that price, under the opposite belief that prices will rise. When management bases hedge implementation decisions on price views, they are implicitly indicating that they have the capability to beat-the-market. And the evidence not surprisingly suggests that they don't have this capability.

The management teams of upstream energy producers are typically very good at a lot of different things - the finding and development of reserves, cost control, and the pursuit of profitable growth strategies to name a few. But they did not reach their positions because of an inherent ability to trade commodity markets. In fact the concern around a trading skill level is highlighted by the way "hedge" transactions are often managed. If the hedges move a little in-the-money, there is often a tendency to liquidate the hedge and take profits. However, if the hedges begin to lose money, they are left in place because of course they are hedges. This is the "cut your profits and let your losses run" strategy that has bankrupted many market traders in the past. And the same strategy is often used on the underlying physical position: hedges are usually established in rising markets (cutting the profits on the underlying future production) and not established in falling markets (allowing opportunity losses to accumulate on the underlying production).

The way to solve this problem is for producers to adopt a true risk reduction objective behind their hedge program that does not contain an element of price view. If stability is desired, then execute hedges in a mechanistic fashion that ensures the hedges will be in place when they are needed. Also, producers should make sure that there is upfront buy-in by the management team and the Board of Directors that hedges will not be benchmarked on the gains and losses generated by the hedges in isolation. Oil and gas producers can learn something from the regulated utility industry where many companies are moving to a more mechanistic hedging approach that limits the role of price view. In the face of regulatory prudence reviews, utilities are beginning to recognize that there is no upside to injecting questionable price views when they have no competitive informational advantage in the commodity markets. While this type of approach may not spark the same kind of adrenalin rush associated with running ahead of the Pamplona bulls or managing a price-view driven hedging program, it will lead to the longer-term fulfillment of the objective to reduce cash flow volatility, and the consistency of the program will generate more support among shareholders and investment analysts.