edging simply means locking a fixed price or a price range for a portion of our future oil and gas production. By securing an established price range for a portion of our production, hedging helps us minimize the impact of fluctuating commodity prices on our cash flow. Recently, commodity prices have been extremely volatile. Without hedging, this volatility could result in large swings in cash flow and distributions. ARC believes in stable and sustainable distributions and hedges to achieve these results. ARC’s hedging program has three primary objectives. First, to provide greater certainty and stability to distributions and unitholder returns. Our hedging program is designed to mitigate downward fluctuations of commodity prices on a portion of our production. Should the price of the commodities rise and our cash flow increases, ARC may increase the cash distribution; however, we will only receive part of the benefit of higher prices as we will have given up some of the upside to protect our cash flow in times of low commodity prices, thereby providing more stability. We believe that stable distributions will result in a more stable unit price.The next objective is to ensure profitability of specific oil and gas properties that may be more sensitive to low commodity prices. Hedging production from these properties assures a minimum, reliable cash flow to ensure continuing profitable operations of these properties.
ARC has a Risk Management Committee that is comprised of ARC’s senior executive officers and market experts from ARC Financial Corporation. This committee meets on a weekly basis to review ARC’s current hedged position and makes decisions on further hedging or modifying hedges already in place. The committee follows an established process put in place to ensure that ARC’s objectives are met. The first step in the process is for the committee to review the current hedging position, not only from a perspective of how much of our volume is hedged but also with whom it is hedged. ARC reviews its exposure to counterparties on a regular basis. We enter into contracts with two types of counterparties by hedging production in two ways. We have financial counterparties with whom we enter into financial contracts through various hedging instruments, all of which are settled with cash. We also have physical counterparties to whom we sell a portion of our oil and gas production at a specific price. It is part of ARC’s hedging policy to follow a “portfolio approach” so that we do not have too much exposure to any individual counterparty. The committee receives information from our market analysts with respect to all aspects of the oil and gas commodity markets – demand and supply for each commodity, storage levels, weather, trading activity and both national and international political situations.
Management Finally, we want to take advantage of upswings in the market by locking in prices at levels that are significantly higher than historic averages. We understand that oil and gas prices are subject to degrees of volatility and we take into consideration the fact that extremely high prices and very low prices are not sustainable over the long-term. The hedging program is designed to give up a portion of the upside from extremely high commodity prices to avoid the downside of low prices. In January 2003, our industry enjoyed very healthy oil and gas prices; however, history has shown that prices at these levels are not sustainable. Locking in a portion of our production at higher prices allows us to protect our unitholders’ return on their investment for a period of time after commodity prices fall.
Based on the committee’s review process, a decision is made on whether it is appropriate to enter into additional hedges and if so, what commodity to hedge, how much of the commodity will be hedged, the price and terms. The contracts for the hedges are selected from competitive bids, again, keeping exposure to counterparties in mind. ARC has a policy that we can hedge up to 70 per cent of a commodity for a period of up to one year, but we cannot hedge over 50 per cent of our combined production without specific board approval. There are circumstances where longer term hedging is allowed. It is important to note that ARC does not hedge to speculate. We take a disciplined approach to assess and take advantage of hedging opportunities to stabilize distributions.