This is an interesting current article from Alberta Oil Magazine about hedging. I was going to post in the OT forum until I came across a brief mention of Connacher towards the end. I particulary found the "mark-to-market" discussion interesting. Apparently though hedging may be good in practice, it can cause swings in income on paper, which can be somewhat deceiving.

I won't post the whole article, just the paragraphs I found most interesting, though the whole article is good reading. -bbq

http://www.albertaoilmagazine.com/

Mastering Cycles

Violent market storms test the industry’s ability to dodge financial wreckage

by Sydney Sharpe

1. In spite of such uncertainties, the level of hedging in the oil side of the industry isn’t very high. “Most of the companies who’ve done hedging have left a fair amount of money on the table,” says Martin Molyneaux, FirstEnergy Capital Corp.’s managing director of institutional research.

Companies use programs known as the costless collar. This establishes a band of prices for production which are essentially the top and bottom on the commodity-futures contract. With a collar price of oil between $80 and $100 a barrel, for example, the company is protected on the downside and upside but doesn’t really give anything up by way of foregoing revenue until oil moves considerably above $100. The collar provides the company with a range to ride price fluctuations by locking in a price floor while taking advantage of the price ceiling. “The companies have used these kinds of programs and it doesn’t cost anything to do it,” notes Molyneaux.

The big difference in recording effects of hedging today occurs at the end of each financial quarter. Accountants, obeying standards set by U.S. financial regulators, demand that companies disclose their hedging positions in a form known as “mark-to-market.” The rules require disclosure of differences between the par value of hedges and current market prices. As a result, on the June 30 closing date of second-quarter 2008, a number of companies’ financial statements showed large losses taken on mark-to-market positions.

Imagine, for example, having to show the value of your house and hence, your net worth, every quarter. As the retail house market rises and drops, so does your home’s worth – even if you have no plans to sell. “Hedging creates more near-term volatility in earnings,” explains Molyneaux. “Yet it has no effect on cash flow. I can’t understand why the accountants do mark-to-market positions. It’s noise in the system.”

There’s already enough shouting in the economy. Mark-to-market adds even more complexity for industry leaders and investors as they try to navigate the financial spectrum. “Every time one of these companies announces big earnings up or down because of these contracts, it causes a lot of confusion,” adds Molyneaux.

In August, Penn West Energy Trust, for instance, reported a second-quarter loss of $323 million and year-to-date hedging losses of $1.3 billion. Yet these weren’t really losses, but simply book entries, noted chief executive officer Bill Andrew in a conference call for financial analysts and media the next morning.

“We have to remember that accounting regulations require mark-to-market hedges. We basically take a point in time, take the price at that point in time, then take all of our future hedges and say, ‘What is the lost opportunity? What is the price we will not realize?’ The billion dollars that you talk about is a book entry.”

Tristone Capital Inc.’s Tom Ebbern also believes collar programs don’t belong in earnings statements. “Companies shouldn’t have to take that as a loss on income – it’s a balance sheet issue, not an income issue,” says Ebbern, managing director of institutional research. “It’s a non-cash issue and it makes earnings harder to understand.”

2. There are companies with natural hedges. The integrated oil and gas operators produce oil and then consume it in their refining operations. The diversity gives them built-in protection against market slides. Low crude prices hurt their production sides but cut raw material costs for their refineries. High crude prices squeeze refineries but enrich production departments.

Yet even that strategy can fizzle with fickle prices. Harvest Energy, for instance, became Canada’s first integrated energy trust by buying North Atlantic Refining in 2006. The plant, located in Come By Chance, Nfld., was problem-plagued in the 1970s before it became profitable in the 1980s. “This should reduce cash flow volatility through various business cycles,” Harvest chief executive officer John Zahary predicted when his firm bought the refinery. It provides “exciting opportunities.”

Two years later, soaring oil prices raised feedstock costs for the refinery. The company’s second-quarter 2008 results revealed a disappointing downstream performance, with the refinery barely breaking even. It was “challenged by the rapid rise of crude oil prices and the lagging finished product markets,” Harvest told investors in its financial statement. In a research note to clients, FirstEnergy Capital vice-president Jill Angevine highlighted risks. She observed that “weak refining margins, which are 46 per cent lower year-to-date versus 2007, have made it difficult for Harvest’s balance sheet.”

While Harvest remains committed to its downstream business, it’s also seeking a partner for a $2-billion refinery upgrade. Finding that partner, in the words of Harvest, “interested in participating in such an investment opportunity” is tough when the cost of oil is high and the economy is in flux. Yet Harvest also states, “Despite the financial challenges faced by the refining industry today, it is a cyclical business that we firmly believe will make a more significant contribution to our cash flow in better markets.”

Provident Energy is another integrated trust, but with a natural gas liquids midstream and marketing division instead of an oil refinery. Yet Angevine noted it is highly leveraged in both parts of its business. The integrated approach can also be a little confusing for investors familiar with companies that concentrate more on traditional exploration and production and less on refining.

That does not prevent firms from trying the diversification approach, known for generations in the oil industry as the “integrated” company. Connacher Oil and Gas believes its strategy of mimicking, on a small scale, the international oil giants enhances its oil sands business.

“We call it the Rockefeller solution,” says Connacher president Dick Gusella, referring to the 19th-century creator of the Standard Oil formula. John D. Rockefeller went into every aspect of the business from exploration drilling to fuel retailing.

Connacher’s second-quarter 2008 results highlighted strong bitumen prices but pointed to its Montana refinery as standing on guard against market reversals for the raw oil sands product. The plant’s profits were squeezed while oil prices stayed high, but it “enables us to recoup a portion of widened differentials (bitumen price discounts), should they re-emerge, so we have a less volatile and more predictable revenue and cash flow stream as a result of our integrated strategy.”

Although the fall financial collapse prompted Connacher to suspend plans for a refinery expansion, the firm earlier credited its integration strategy with obtaining long-term U.S. financing for its Algar oil sands expansion project at its Great Divide site south of Fort McMurray.