Are Oil, Gas Producers Hedging?
With the price of crude oil dropping in November 2014, many are asking if oil and gas producers are hedging at the current price levels. The following is a survey of the 30 largest public oil and gas producers and their hedging activities as disclosed in their Dec. 31, 2016 10-K filings.
The following survey provides as much information as possible based on what was disclosed in the filings. U.S. GAAP accounting rules form the minimum disclosures companies must provide in their filings to provide users with an understanding of:
- An entity’s use of hedges;
- How the hedges and the hedged production are accounted for in the filing; and
- How the hedges affect the financial statements
While the accounting rules require entities to disclose their level of derivative activity, there can be variance in practice as to how much information companies disclose about the instrument types, volume of production hedged and the average hedge price.
The purpose of a risk management program is to protect a plan or a path forward. Upstream companies face a variety of business risks that could limit their progress toward achieving a plan, particularly as commodity prices remain volatile and depressed.
Upstream companies have relatively straightforward objectives, which are to search for, develop, and extract hydrocarbons. In doing so, upstream companies must have enough cash flow not only to support a level of capex and exploration activity to ensure that oil and gas continues to flow, but also to make debt payments, comply with debt covenants, and support the associated general and administrative costs.
Hedging programs at upstream companies are developed with the primary purpose of providing a level of cash flow to increase the likelihood of meeting those needs.
Without the protection of an effective hedging program, an upstream company’s cash flows are subject to the volatility of the market. An upstream company without hedges will benefit from higher market prices, but they have a very short amount of time to react when market prices decline. This is a predicament many upstream companies have experienced during the most recent price downturn. This is likely why 97% of the companies in the survey have hedges in place.
Not all hedges are created equal. While some companies will state that they have a hedging program and have executed hedges, the downside protection provided by those instruments may not be that significant.
For a producer, swaps provide the highest amount of downside protection. However, swaps also are often the most limiting for upside price participation. This leads producers to utilize purchased puts, which can be costly, or costless collars, which allow producers to participate within a range of price movements.
Other instruments noted in the survey were swaptions and three-way options. Swaptions represented a minority of the instrument types utilized by the public companies. The use of three-way options (purchased put, sold call and sold put) were common in higher price environments when oil prices were over $80 per barrel (bbl).
However, many producers were hurt by this strategy, as it contains what some consider a trap door. For example, a producer with a $40 sold put, $50 purchased put, and $60 sold call, would participate in price movements between $50/bbl and $60/bbl. However, once the price goes below $40/bbl, the company would have no downside protection as the price falls below $40/bbl. This was particularly painful for many producers in 2014 that had sold puts in the $65 to $75 range, believing that prices could never go below those levels.
Of the public oil and gas companies reviewed, there was a higher prevalence of three-way options for crude hedges than the use of straight purchased puts. However, swaps and costless collars are the most prevalent for both natural gas and crude hedges.
Length of Hedging
Hedging programs are not a permanent fix when price declines continue for a long period of time. In the most recent downturn, many of the upstream companies with attractive hedging portfolios were hedged 12 to 24 months ahead of their future production, which shielded them during 2015 and a portion of 2016.
Based on the survey results, the number of companies hedging crude and natural gas in 2017 was roughly the same; however, a higher number of companies hedged natural gas in 2018 than hedged crude in 2018.
Of the 30 companies surveyed, for crude, 24 companies hedged 2017, 14 companies hedged 2018, and three companies hedged 2019 or beyond. For natural gas, 23 companies hedged 2017, 19 companies hedged 2018, and five companies hedged 2019 or beyond.
The ability to only hedge at the top of the market is impossible. The decision of when to hedge and at what price level is rooted more in the risk management policy of providing predictable cash flows than in an ability to predict prices. Because a hedging program is intended to increase cash flow predictability, the price level at which companies execute hedges is often heavily influenced by operating budgets and debt compliance.
After many companies restructured their balance sheets in the past few years and successfully negotiated lower operating costs, their breakeven production price decreased as well. Many companies executed hedges at pricing levels that exceeded the breakeven production price and provided for a reasonable return.
For the 26 companies that disclosed hedged price levels, the average swap price for crude was $50.64 for 2017 and $53.50 for 2018, and natural gas was $3.15 for 2017 and $3.06 for 2018. The average put price (non- three-way) for crude was $47.42 for 2017 and $48.54 for 2018, and natural gas was $2.95 for 2017 and $2.94 for 2018.
Unfortunately, few of the companies reviewed disclosed the amount of their forecast production that was hedged as of Dec. 31, 2016. Only four companies disclosed the percentage of forecast production hedged. For the companies that did disclose this information, the average hedge level for crude was 42% of forecast 2017 production, and for gas, was 52% of forecast 2017 production.
Implementing an effective hedging program can help ensure certainty of cash flow and perhaps prevent having to file for bankruptcy. Management teams are encouraged to consider the various alternatives and strategies that a hedging program can provide in meeting their ever-changing business plans.
Shane Randolph is a managing director at Opportune LLP.