Hedging is a risk-management tool designed to help producers maximize earnings and cash flow by allowing them to take advantage of commodity-price spikes while at the same time protecting them against oil and gas price dips. But entering into such transactions with hedging counterparties traditionally carries with it one inherent risk for operators: the need to post collateral in the form of cash or letters of credit (LOCs)-often in very large amounts-to satisfy potential margin calls in the event the cash market moves against those operators. Acutely aware of this going into 2004 was Oklahoma City-based Chesapeake Energy Corp. Primarily a Midcontinent producer with an aggressive growth program, it wanted to take advantage of historically high natural gas and oil prices by hedging a substantial portion of its expected production for the next five years. Specifically, Chesapeake wanted the ability to hedge an aggregate 450 billion cubic feet equivalent (Bcfe) of output over that period at an average gas-equivalent price of $6 per thousand cubic feet (Mcf). Equally important, the operator wanted to do this in such a way that it wouldn't have to post cash or LOCs with a hedging counterparty any time market prices moved higher than its $6 hedged position. It's a simple fact of life that the posting of cash-collateralized trading lines can be the source of considerable liquidity concerns for any independent the size of Chesapeake, which at any moment may have hundreds of Bcf of gas hedged. "If, in a typical transaction with a counterparty, we hedged 250 Bcf of gas at $6 and the cash market rose to $7, that $1 move times 250 Bcf would require us to post $250 million of collateral in the form of cash or a letter of credit," explains Marc Rowland, Chesapeake executive vice president and chief financial officer. "So we recognized we needed to find a way to solve such a potentially huge cash-call and liquidity issue, which faces any large producer engaged in a lot of hedging." That solution? Enter Deutsche Bank Securities in New York. "One of the first things we noticed about Chesapeake is that the company typically keeps its bank facility relatively small. As a result, there was a lot of under-utilized reserve collateral available," says Michael V. Johnson, managing director and Americas head of the energy, utilities and chemicals group for the investment-banking firm. This situation, Johnson points out, is in direct contrast to that of other lower-rated producers that generally use all or most of their reserves to collateralize their bank facilities. "We thus saw an opportunity to take advantage of Chesapeake's excess collateral position to address its goal of not being subject, in its hedging program, to posting cash or LOCs for margin calls." In the hedging structure that Deutsche Bank Securities created for Chesapeake, the producer on an annual basis pledges a specified portion of its proved developed producing (PDP) reserves as collateral against any margin call, in an amount equal to a multiple of the maximum potential future exposure (PFE) by Deutsche Bank under the facility, explains Jerry Schretter, managing director and Americas head-energy for Deutsche Bank Securities. He notes that PFE is a Deutsche Bank proprietary calculation that values possible future credit exposure to a 95% confidence level. "Simply put, Chesapeake is using PDP reserves instead of cash to collateralize its hedging position." In this hedging arrangement, put into effect in June 2004, Chesapeake pledged $900 million of PDP reserves to Deutsche Bank Securities to collateralize a $600-million credit facility. "One can think of this as a non-advancing, standby LOC facility," says Rowland. "In other words, Deutsche Bank isn't advancing us cash; rather, it's advancing us collateral in the form of margin-call protection, up to $600 million." The reason this hedging structure works so well for Deutsche Bank is that it's predicated on "rightway risk," explains Johnson. "This means that the value of the collateral pledged to us goes up as our exposure goes up. In other words, if gas prices go higher, then the reserves that Chesapeake has pledged to us are worth more money." The producer also benefits, stresses Schretter. He notes that Deutsche Bank created a proprietary hedge-syndication structure that enabled the financial institution to offer the producer overall transaction pricing significantly cheaper than the cost of Chesapeake's existing secured bank revolver. "Looked at another way, when the company compared the cost of this hedge structure to the cost of previous hedges it had done without having to post asset-based collateral, it viewed this one as being as good or superior in terms of pricing." Using its unique hedge-syndication structure, Deutsche Bank was also able to lay off a substantial portion of the transaction's credit risk to some non-bank capital providers, thereby deepening Chesapeake's credit investor base, says Schretter. Adds Johnson, "What Chesapeake also got-and this can't be overstated-is a firm commitment for a large-volume hedge with just one financial counterparty; this keeps a hedging transaction quiet and allows an operator to get the best transaction pricing without moving the [commodities] market." Rowland notes that hedging has been, and continues to be, a very integral part of Chesapeake's overall corporate strategy. Indeed, the operator-whose company-wide output is roughly 1.2 Bcfe per day-is typically 50% hedged; this year, its output is 48% hedged on average. "Through hedging, we're able to take advantage of commodity-price spikes, which we've seen periodically in natural gas, caused either by weather or oil-price movements," he says. "Now, with the hedging structure we've put in place with Deutsche Bank, we can hedge without the fear of having an ensuing liquidity crisis should gas prices continue to move up." Case in point: if, as the result of a hurricane, the price of gas rises to $9-and the company decides to hedge under the Deutsche Bank structure several hundred Bcf of gas at that price-it wouldn't be worried about gas prices jumping to $11. Very simply, there wouldn't be any $2-per-Mcf cash call to put a strain on the firm's liquidity. "The value of hedging is that it provides us additional margins on our oil and gas production because we put our hedges on at high commodity-price levels," says Rowland. "This, in turn, enhances earnings and cash flow." For 2004, Chesapeake reported net income available to common shareholders of $439 million versus $290.5 million for 2003 and $30.2 million the prior year. Operating cash flow, meanwhile, rose to nearly $1.42 billion from $904 million in 2003 and $412.5 million in 2002. The company reported similar operating gains, with daily 2004 production rising to 991 million cubic feet equivalent, up from 735 million in 2003 and 487 million in 2002. Also, proved reserves shot up from 3.17 trillion cubic feet equivalent at the start of 2004 to 4.9 trillion at year-end. Back to Deutsche Bank Securities and the obvious question: has it replicated its asset-collateralized hedging structure for other E&P companies? "Not yet," says Johnson. "However, we're currently in dialogue with several independent producers with similar unpledged reserve profiles."