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The business model surrounding Volumetric Production Payments, (VPPs), invariably revolves around forward payment on oil and gas to the producer who uses this capital to potentially ramp up production from their existing fields by re-works, drilling PUDs, re-completions, etc., but also from the investor's view and how they can address the capital risk.

The producer and the buyer of the VPP are not at a tug-of-war with each other as a typical bank / private equity relationship lends itself to be.  The VPP buyer wants to see the producer succeed like a bank or private equity firm does, naturally, however, there are distinct benefits the producer and investor can enjoy unlike their financial brethren.

The delivery schedule defined by the producer and buyer allows far more leeway than from a loan.  Usually, the producer is given some lead time to use the capital to ramp production and, as anyone knows in this business, things occur that can't be foreseen that has a less sever impact on the VPP.  Should the producer not be able to make the stated amount due on the delivery schedule for the month, it can be rolled over without penalty, unlike a loan or the raised hackles of the private equity firm who'll own a large chunk of the firm anyway.

For the buyer of the VPP, to manage the commodity-price risk, a hedging strategy must be enacted.  There is a much heavier emphasis on hedging as a risk mitigant for companies that have any degree of leverage.  Actual prices in the future might prove the NYMEX wrong, but there is a common yardstick by which reserves can be measured, favoring the investor who puts up the capital.

Risk mitigation starts at the commencement of the transaction.  The producer and buyer agree at a price for the forward sale at a discount and after determining how much of that production is needed to be 'sold' for the term of the VPP to satisfy the capital needs advanced to the producer, the hedging process starts.

At this point its academic.  Prices 3-4 years out? Go in and lock the price in the derivatives market.  The old days of oil and gas executive 'group think' as to future pricing is archaic.  NYMEX take this equation and bends it.  It renders a strip.  The strip might be right or wrong, but it gives the buyer a basis on which to make an intelligent bid, as the buyer perceives the upside to be.

The three-legged stool involving the producer who needs capital, the buyer, who provides it and the futures market make for great partners where the upside can be exploited with the buyer comfortable the risks have been addressed via the derivatives market.

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