While the U.S. oil and gas sector makes extensive use of derivatives to manage commodity price risk, and in some cases make a speculative buck, Standard & Poor’s Ratings Services (S&P) said producer hedging practices have little impact on corporate credit ratings. This is mainly due to the fact that most companies hedge production only as far out as two years or so, and the ratings agency takes a longer-term view when assessing credit.

Still, S&P credit analysts found producer hedging to be of enough significance to pen a research note of eight pages, plus tables. Among the 140-odd oil and gas companies rated by S&P, those most likely to eschew hedging and ride the market are the big producers, and otherwise, their commodity hedges generally aren’t material to corporate results, S&P said.

Companies with lower credit ratings, independents, are far more likely to hedge commodity risk, S&P said, but this has little overall impact on how the agency rates them.

“While perhaps counterintuitive, the degree to which a company hedges does not materially affect its corporate credit rating in most cases. Corporate credit ratings reflect a company’s long-term ability to meet debt service requirements. In most cases, hedges only cover one to two years of anticipated production, and therefore do not mitigate cash flow volatility risks over the longer term.”

Still, hedging can help companies with speculative ratings in two ways. For one, S&P said it can more confidently predict near-term cash flows when a significant portion of anticipated production is hedged. Second, a consistent hedging policy may reflect a more conservative financial policy.

“However, surprisingly few companies, in our opinion, have demonstrated a consistent policy of hedging commodity price risk through the cycle,” S&P said. “Merely having hedges in place does not necessarily indicate a conservative financial policy. Some companies attempt to time the market and will actively enter and exit hedges to try to maximize shareholder value.

“From a rating perspective, trading for profit could indicate that management has a tolerance for higher risk.”

When hedges are out of the money they can put a damper on a company’s upside potential. However, S&P evaluates this circumstance in terms of its impact on credit quality on a case by case basis, and the firm takes a relatively sanguine view of underwater hedges. “We rate to relatively conservative price assumptions and much of the hedging losses would dissipate in a lower price environment.”

In the note, S&P provided its commodity price assumptions as of May 9. Henry Hub natural gas is pegged at $7.00/MMBtu, $5.50/MMBtu, and $4.50/MMBtu in 2006, 2007, 2008, respectively. WTI crude is pegged at $60.00/bbl, $50.00/bbl, and $40.00/bbl in 2006, 2007, 2008, respectively.

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