Monthly Archives: June 2012

“A lot of weather we’ve been having lately.”

The winter of 2011-2012 was the fourth warmest on record in the U.S., according to the National Oceanic Atmospheric Administration (NOAA). One consequence of this has been a sharp drop in demand for natural gas use to heat buildings, and that is a hit to the bottom line of many gas distribution utilities with revenues tied to the quantity of gas consumed. For example, the Delta Natural Gas Company, a Kentucky utility, reported in its second quarter 10Q that:

Heating degree days were 78% and 84% of normal thirty year average temperatures for the three and nine months ended March 31, 2012, respectively, as compared with 102% and 105% of normal temperatures in the 2011 periods. … For the three months ended March 31, 2012, consolidated gross margins decreased $890,000 (7%) due to decreased regulated and non-regulated gross margins of $707,000 (7%) and $183,000 (6%), respectively. Regulated gross margins decreased due to a 26% decline in volumes sold as a result of warmer weather, as compared to the same period in the prior year. … Non-regulated gross margins decreased due to a 26% decline in volumes sold due to a decline in our non-regulated customers’ gas requirement, partially offset by a decline in the cost of gas and the sale of natural gas liquids.

Some of this quantity risk might be hedgeable using weather derivatives. And hedging this risk can decrease the volatility in corporate cash flow, increasing both the company’s debt capacity and its dividend ratio and ultimately raising shareholder value.

A research paper by Francisco Pérez-González of Stanford University and Hayong Yun of the University of Notre Dame, forthcoming in the Journal of Finance, uses this setting to explore the question of whether financial innovation is useful to the real economy. They take the case of the innovation of weather derivatives in 1997 as a kind of natural experiment and explore the cash flow volatility situation for natural gas and electric utilities before and after the introduction of this risk management tool. Altogether, they examine stock market and financial statement data on 203 companies over the years 1960 to 2007. Their data show that the utilities most likely to use weather derivatives are those with the greatest cash flow sensitivity to weather, and that those that do make use of the derivatives significantly decrease the volatility of their cash flows. This increases the debt and dividend ratios of these utilities, and ultimately their share prices, too.

Chesapeake’s Two Natures

In yesterday’s post I said that Chesapeake’s management was speculating on natural gas and oil prices. But Chesapeake claims that it is a hedger. Speculating and hedging are different things, so is Chesapeake a hedger or a speculator?

In representations to regulators, Chesapeake’s Vice President for Finance and Assistant Treasurer, Elliot Chambers, has stated categorically that “we never speculate.” Is that true? Is his definition of a speculator the same as mine?

Chesapeake is a hedger. It uses exchange traded futures and options, OTC swaps, and a specialized financing vehicle called Volumetric Production Payments, among other things, to mitigate the price risk on its production and “predict with greater certainty the effective prices we will receive for our hedged production.” (10K for FY2011 p. 72)

But Chesapeake is also a speculator. The company is straightforward in its SEC filings that it tries to profit off of price swings: “We intend to use this volatility to our benefit by taking advantage of prices when they reach levels that management believes are either unsustainable for the long term or provide unusually high rates of return on our invested capital.” (10K for FY2011 p. 6) “Depending on changes in natural gas and oil futures markets and management’s view of underlying natural gas and oil supply and demand trends, we may increase or decrease our current derivative positions.” (10K for FY2011 p. 59) “Our general strategy for attempting to mitigate exposure to adverse natural gas and oil price changes is to hedge into strengthening natural gas and oil futures markets when prices allow us to generate higher cash margins and when we view prices to be in the upper range of our predicted future price range. Information we consider in forming an opinion about future prices includes general economic conditions, industrial output levels and expectations, producer breakeven cost structures, liquefied natural gas trends, natural gas and oil storage inventory levels, industry decline rates for base production and weather trends.” (10K for FY2011 p. 87) As I related in yesterday’s post, Chesapeake’s decision last fall to remove its natural gas hedge was based on its prediction that prices were temporarily low and would recover, allowing it to replace the hedges and capturing a profit on the short-run volatility. This is all speculation.

A company can be both a hedger and a speculator.

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Chesapeake takes its eye off the ball

Chesapeake Energy has been going through a shake-up of late, most recently at Friday’s shareholder meeting. The low, low price of natural gas is contributing to a cash squeeze. This has made all the more vital the many debates about corporate governance and the company’s investment strategy. To the list of items needing review, I would add the management’s short-term speculations on natural gas and oil prices.

Here’s a slide from a deck distributed in advance of last week’s meeting:

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Deleveraging and the creation of the Eurozone Keiretsu

Many Eurozone banks are going through huge deleveraging: they are selling their portfolios of loans to hedge funds, reducing and cutting revolvers to corporations, and shortening the overall maturity of their exposures. Faced with higher capital requirements as they experience melting equity values, and unable to raise funds from the US money market, European banks are left with no options but downsizing and help from the European Central Bank.

The banks’ deleveraging is paralyzing the European economy. Even healthy borrowers can’t be certain they’ll have the loans and lines of credit necessary for their regular operations. Many are going capital light: cancelling investments, shrinking working capital and selling non-core assets. Banks’ deleveraging has fostered a downward spiral amplified by institutional and retail investors dumping the stocks and bonds of banks and bank dependent borrowers. This is particularly nasty for the Eurozone, given the role banks have traditionally played in funding European firms.

New forms of intermediation are being developed. The most vigorous are via internal capital markets. Holding companies are tightening their grip over funds available at their subsidiaries—even when these are exchange listed companies—and are playing a much more prominent role in the allocation of funds.

A few large corporations are going beyond that and creating their own banks to make up for the vacuum created by the banks disappearing from the funding scene. Having a bank allows these corporations direct access to funds from the ECB, and enables them to store their excess liquidity in-house, instead of in deposits at outside banks that may be vulnerable to runs. The European aerospace firm EADS is considering doing just that. EADS’ bank could be the financial center of a large network of entities with business relations with the corporation, each with access to funds and able to deposit funds with EADS bank. If one counts EADS’ suppliers and major customers, as well as the suppliers of EADS’ suppliers and all their employees combined, that could be a very large bank indeed.

Out of necessity, the European Keiretsu is born!

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