Case Study: Burns Energy Associates
Note: This project was completed on April 15, 1998 prior to the issuance of SFAS 133.
Overview
February 1, 1997
Burns Energy Associates is a natural gas and oil exploration and production company with fields in the Southern Rockies. In recent quarters, problems with the installation of production equipment have delayed planned production in a major field and this has hurt earnings and planned revenue generation. The resulting drain on the company's liquidity resources has forced management to reschedule planned exploration activities and re-evaluate their business plans.
Natural gas production accounts for 70 percent of the company’s revenues. Generally, the company has been bullish on natural gas pricing (Burns earns 3¢ under the Permian Basin Index). In better times, a favorable price view like this meant no hedging. However, in current circumstances, Burns is concerned about a surplus developing in the market and prices of natural gas collapsing unexpectedly in the months ahead. Prices have been significantly decreasing due to unexpected weather patterns, production problems, and customer demand.
A fall in the company’s price realizations below $1.05/MMBtu would result in negative cash flow, which Burns cannot now afford. Management’s priority is to pay down the heavy debt burden the company took on to develop these new properties. Any postponement of debt service will be devastating to the future growth of the company.
The company has requested a variety of quotes for hedging their production of natural gas for the upcoming 18-month period. All quotes are based on a monthly planned production of 4.0 million MMBtu.
You are a brilliant financial analyst for the Smithers Investment Group and have been contracted to work on this case. The company has asked for your hedge strategy recommendation.
Relevant Information
Futures Options Prices
Natural Gas -New York Mercantile Exchange (NYMEX)
10,000 MMBtu; $ per MMBtu
Calls - Settle |
Puts - Settle |
|||||
Strike Price |
June |
July |
August |
June |
July |
August |
1.120 |
1.065 |
1.130 |
1.125 |
0.780 |
0.940 |
0.845 |
1.170 |
1.042 |
1.125 |
1.100 |
0.785 |
0.950 |
0.850 |
1.240 |
1.035 |
1.123 |
1.094 |
0.855 |
1.025 |
1.010 |
Futures Contracts
Natural Gas - NYMEX
Price - $ per MMBtu
| Futures - Price Index | June |
July |
August |
| Henry Hub | 1.785 |
1.950 |
1.773 |
| Permian Basin | 1.200 |
1.600 |
1.584 |
18-Month Floors Against the Permian Basin Index
| Strike Price - $ per MMBtu | Floor Premium (Offer) |
| 1.120 | $3.390 MM |
| 1.170 | $5.340 MM |
| 1.240 | $7.098 MM |
18-Month Caps Against the Permian Basin Index
| Strike Price - $ per MMBtu | Cap Premium (Bid) |
| 1.320 | $7.098 MM |
| 1.370 | $5.340 MM |
| 1.420 | $3.390 MM |
Burns Energy Associates borrows at a rate of 10.0 percent per annum. The current Permian Basin price index is $1.200 per MMBtu.
