Has Oil and Gas Hedging Changed?
By Shane Randolph and Josh Schulte
Over the past year, oil and gas producers have largely experienced higher crude prices with lower natural gas prices. The hedging practices have changed as a result. The following is a survey of the 30 largest public oil and gas producers and their hedging activities as disclosed in their Dec. 31, 2017 10-K filings with comparisons to the same survey done in the prior year.
The following survey provides as much information as possible based on what was disclosed in regulatory 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
· How the hedges affect the financial statements
While the accounting rules require entities to disclose the level of an entity’s derivative activity, there can be variance in practice as to how much information a company discloses about the instrument types, volume of production hedged and the average hedge price.
Upstream companies have relatively straightforward objectives, which are to search for, develop and extract hydrocarbons. These activities are very capital intensive and require large amounts of cash. Companies have enough cash flow not only to support a level of capital expenditures 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 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 experienced during the most recent price downturn.
The following outlines the percentage of companies in the survey that maintained hedges as of December 31, 2017 for crude, natural gas or natural gas liquids (NGLs). Consistent with the prior year, it is clear that the majority of public oil and gas producers are maintaining hedging programs.
While some companies will state that they have a hedging program and have executed hedges, investors should carefully consider the types of instruments utilized. The downside protection provided by some instruments may not be that significant. The following notes the number of companies holding various instrument types in their hedging portfolio.
For a producer, swaps provide the highest amount of downside protection. However, swaps limit upside price participation. This leads producers to utilize purchased puts, which can be costly, or costless collars, which allow the producer to participate within a range of price movements. Other instruments noted in the survey were swaptions and three-way options. Swaptions continue to represent 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 have been 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 and $60. However, once the price goes below $40, the company would have no downside protection as the price falls below $40. This was particularly painful for many producers in 2014 that had sold puts in the $65-$75 range under the belief that prices could never go below those levels.
Of the public oil and gas companies reviewed swaps continue to be the preferred instrument for both natural gas and crude. For crude, the use of purchased puts, collars and three-way collars is consistent with the prior year. However, the use of three-way options has increased for natural gas with a slight reduction in the use of swaps and costless collars.
Length of Hedging
When executing a hedging program many companies are challenged with how far out to hedge their production. If the prices increase over time they largely give up the upside. However, if the prices drop, it allows the company to weather the storm for a longer period of time. Based on the survey results, the number of companies hedging crude and natural gas in 2018 was roughly the same; however, a higher number of companies hedged crude oil in 2019 than companies hedging natural gas in 2019.
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 cashflows than in an ability to predict prices. As a hedging program is intended to increase cashflow predictability, the price level at which companies execute hedges is often heavily influenced by operating budgets and debt compliance.
For the 26 companies that disclose hedged price levels the average swap price for crude was $54.60 for 2018 and $52.71 for 2019 and natural gas was $3.05 for 2018 and $2.94 for 2019. The average put price (non- three way) for crude was $48.34 for 2018 and $47.77 for 2019 and natural gas was $2.98 for 2018 and $2.94 for 2019.
Consistent with the prior year survey few companies disclosed the amount of their forecasted production that was hedged as of December 31, 2017. Only five companies disclosed percentage of forecasted production hedged. For the companies that did disclose this information, the average hedge level for crude was 55% of forecasted 2018 production and for natural gas was 40% of forecasted 2018 production. Note that these hedge levels include coverage provided by three-way options.
In summary, hedging practices have changed slightly in the past year. Most things have remained the same, but the mix of instruments used is starting to shift. Implementing an effective hedging program can be a tool that helps ensure certainty of cash flow and perhaps avoid 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. Opportune is the premier hedge execution advisory and financial advisory firm for the upstream energy sector. Our professionals offer the unique understanding of the hedging and operational processes that allow us to present alternatives that meet the needs of upstream companies during these volatile times.