Hedging to Hemorrhaging

Abstract

The implementation of an effective hedging program can be a tool that helps ensure certainty of cash flow and provide longer reaction time in the event of a market price collapse. On the flip side of the coin, if prices rebound as they did in the first quarter of 2021, producers are left behind while the market surges. With United States E&P Companies projecting $7 billion in hedging losses for the quarter, it will be important to keep a close eye on which companies choose to continue to hedge early for guaranteed revenue protection and those that hold out or hold off to risk the market volatility in hopes of even more revenue. 

Key Points

  • After a volatile year of oil and gas commodity prices in 2020, many E&P companies locked in 2021 hedges during the final quarter of 2020. Overall, U.S. companies hedged 41% of the total forecasted 2021 oil output at a WTI price of  $42/bbl. For comparison, the average oil hedge floor throughout 2020 was about $56/bbl. 

  • As prices rose above $40/bbl near the end of 2020, many operating companies raced to lock in prices for 2021 production. Companies like SM Energy, Ovintiv, and Chesapeake are some of the top companies that have between 58% and 78% of production volumes hedged below $50/bbl in 2021. Selling these volumes at below-market prices has weighed on many companies’ Q1 earnings this year.

  • As earnings for the first quarter of 2021 come out, some companies have announced major lost revenue due to hedging decisions. Enverus estimates a Q1 loss of nearly $7 billion across 66 companies due to hedging. Diamondback Energy anticipates $102 million in hedging losses, Cimarex expects about $162 million loss in oil and gas derivatives, and Pioneer Natural Resources announced a $691 million loss from hedging.

  • Hedging oil and gas prices is a very common practice for companies to protect against downside risk. It can be a positive choice or a negative one depending on market conditions and volume commitments. For the companies that did hedge large volumes below $50/bbl, continued capital discipline can be expected as they try to maintain cash flow until the hedges roll off later in the year.

Introduction

In early Q1 2021, the RARE PETRO Media Team highlighted that the dramatic price decline of oil in 2020 illustrates the risk every oil and gas producer faces with energy commodity price volatility. Companies with hedged production volumes in 2020 were left in a much better position than those who had foregone the option to reduce the impact of unanticipated revenue declines. Without the protection of an effective hedging program, an upstream company’s cash flows are wholly subject to the volatility of the market. However, the RP Team predicted that with upward price projections for the coming year, institutions distributing hedges to major oil companies for a portion of anticipated production may see greater returns than recent years, most certainly greater than 2020. Many producers raced to lock in sales when crude oil prices rose to over $40 per barrel in the final quarter of 2020, and now are facing huge losses after oil prices climbed to above $60 per barrel during the first quarter of 2021. 

Q4 2020 Hedging 

In the final quarter of a historic 2020, United States E&P companies had hedged 41% of their total forecasted 2021 oil output at an average price floor of $42 per barrel (WTI), significantly lower than 2020’s floor of $56 per barrel [1]. The analysis included 20 producers that collectively account for 32% of 2020 oil output in shale plays and 10 operators whose net production represents more than 20% of the total 2020 shale gas output [2]. A few of the main operators with 2021 hedges included Pioneer Natural Resources, Chesapeake, and Concho Resources, now ConocoPhillips. All of these companies were protected from downward price volatility but were simultaneously limited from potential upward gains. 

Figure 1: U.S. E&P Hedging for 2021 [1]

When the initial impacts of the COVID-19 pandemic began rolling through global markets, producers with the most robust hedge books found themselves better positioned to withstand the low price environment, and many brought this strategy with them into 2021. The problem is, to “lock-in downside protection, producers will typically sacrifice some upside to lower the cost of limiting downside risk. They may even give up some upside on additional barrels that do not have downside protection to further lower the overall cost of the hedging program” [3]. When price projections for 2021 began to emerge after the New Year, RP Analysts became concerned about the extent of this downside protection strategy for domestic E&P producers and noticed significant upside potential for the institutions distributing hedges. 

Q1 Hedge Hemorrhage 

When crude oil prices finally rose over $40 per barrel in the final quarter of last year, many producers raced to lock in hedging contracts for 2021 production over fears of extended demand destruction. Many of the aforementioned firms that hedged portions of their production to protect against downward price volatility missed out on the huge upward price movements experienced during the first quarter of this year. In fact, of the sampled producers, the average ceiling price of 2021 hedged oil volumes was $52/bbl [2]. However, “Occidental’s call options, which were sold to further bolster 2020 hedges, significantly increase this average. Excluding Occidental, oil-focused E&Ps show an average ceiling of just $46.15/bbl” [3]. As prices soared above $60/bbl, producers wholly missed out on upward price movement, and some faced extreme losses for the quarter. Companies including Cimarex Energy Company and Concho Resources that locked in prices on some volumes last year at around $40/bbl missed revenue that would have existed from these price jumps, and Concho owner ConocoPhillips Company was forced to pay millions of dollars to unwind those contracts [4]. Now, U.S. oil and gas operators face billions of dollars in hedging losses that will weigh on first-quarter earnings as this year’s oil-price recovery left dozens selling their oil at below-market prices. 

Figure 2: Price and Volume Commitments for Top Oil Producers Hedged 2021 [4] 

Benchmark WTI crude prices have already doubled from year-ago levels, averaging over $58/bbl for the quarter that ended March 31 [5]. With many earnings reports now released, continued repercussions of the February freeze that temporarily slowed output and massive hedging losses are expected to weigh down on the optimism of surging oil prices. Among those producers impacted are Diamondback Energy Incorporated who recently announced they anticipate $102 million in hedging losses after selling a portion of their oil at $46.81/bbl and Cimarex warned of a $162 million loss on oil and gas derivatives [4]. While they refused to acknowledge the situation before official earnings were reported, Chesapeake Energy hedged about 19 million barrels of 2021 production, a figure that represents a little more than half of its 2020 production, at a price of $42.69/bbl [5]. One producer, Pioneer Natural Resources, has announced their first-quarter results will be hit by a $691 million loss on oil and gas derivatives becoming the latest U.S. shale oil company to warn of charges due to hedging [6]. While that number is staggering, they are not alone. In a review of 66 producers, Enverus estimates U.S. producers face an aggregate $7 billion in hedging losses for the quarter [4]. 

Conclusion 

The implementation of an effective hedging program can be a tool that helps ensure certainty of cash flow and provide a longer reaction time in the event of a market price collapse. One problem is if prices rebound producers are left behind in any market surge. Hedging certainly made sense given the uncertainty of the market in 2020. Even in the final quarter when optimism was high over the sustained balance of global crude oil supply and demand, many producers felt it necessary to hedge future production around $40/bbl after a volatile year marked by a pandemic stricken global economy and commodity prices crashing to historic lows. New investment in oil and gas has shifted in recent years and many producers are playing it safe to ensure they don’t join the 46 North American E&P Companies that declared bankruptcy in 2020 alone [7]. This year’s hedging losses will certainly add additional pressure to keep capital and expense budgets fairly conservative, potentially hampering future spending on drilling or exploration activities until hedges roll off and companies can get market prices for their commodity. Luckily, the news is not all doom and gloom. Hedging is a strategy that many oil companies utilize to protect a portion of their production. While the $7 billion in losses is substantial, oil companies should still benefit from this year’s prices since many typically hedge about half their volumes. As the story of 2021 continues to show upward crude price projections, it will be important to keep a close eye on which companies choose to continue to hedge early for guaranteed revenue protection and those that hold out or hold off to risk the market volatility in hopes of even more revenue. 

References 

[1] https://www.rystadenergy.com/newsevents/news/press-releases/the-2021-oil-and-gas-price-gamble-us-producers-cut-oil-hedge-by-25pct-resilient-gas-only-4pct-lower/ 

[2] https://www.aogr.com/web-exclusives/exclusive-story/producers-weigh-hedging-strategies-for-2021-production 

[3] https://btuanalytics.com/shale-production/2021-oil-hedges-missing-the-upside/ 

[4] https://www.hartenergy.com/exclusives/oil-hedges-crimp-us-shale-producers-first-quarter-profit-193766?mkt_tok=NDMzLU9ESy04ODkAAAF8scFNRnYe2MKzmLISlVAJ_1OW70ibV5CRKcn0I415PDE6rl-6zkZdBduPWE5kla5tefJyAlZOlNh6W5JnHTUwAsDKWYSYJOArDDyNIha2Jszd 

[5] https://www.marketwatch.com/investing/future/crude%20oil%20-%20electronic 

[6]  https://www.hartenergy.com/news/pioneer-natural-resources-warns-near-700-million-loss-hedges-193790?mkt_tok=NDMzLU9ESy04ODkAAAF8tudF2r-orjq836AeSi3NSo7Ll-eH0SZBBM-gRhqycYNr6TOihP5MH03-e7a_T1iP6oo8W9SX4C7ksfyRlb3nX-1PHN-51IKdnu4JyKNYMVzp 

[7] https://www.reuters.com/article/us-usa-oil-hedging/u-s-shale-producers-lock-in-future-sales-as-oil-prices-rise-to-one-year-high-idUSKBN29K0JQ  

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