BackThe oil industry’s $26 billion life raft
That's how much it stands to get paid on insurance bought for protection against a bear marketas long as prices stay low
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For US shale drillers, the crash in oil prices came with a $26 billion safety net. That’s how much they stand to get paid on insurance they bought to protect themselves against a bear market—as long as prices stay low.
The flipside is that those who sold the price hedges now have to make good. At the top of the list are the same Wall Street banks that financed the biggest energy boom in US history, including JPMorgan Chase and Co., Bank of America Corp., Citigroup Inc. and Wells Fargo and Co.
While it’s standard practice for them to sell some of that risk to third parties, it’s nearly impossible to identify who exactly is on the hook because there are no rules requiring disclosure of all transactions. The buyers come from groups like hedge funds, airlines, refiners and utilities.
“The folks who were willing to sell it were left holding the bag when prices moved," said John Kilduff, partner at Again Capital Llc, an energy hedge fund in New York.
The swift decline in US oil prices—$107.26 on 20 June, $46.39 seven months later—caught market participants by surprise. Harold Hamm, the billionaire founder of Continental Resources Inc., cashed out his company’s protection in October, betting on a rebound. Instead, crude kept falling.
Counterparty names
Other companies purchased insurance. The fair value of hedges held by 57 US companies in the Bloomberg Intelligence North America Independent Explorers and Producers index rose to $26 billion as of 31 December, a fivefold increase from the end of September, according to data compiled by Bloomberg.
Though it’s difficult to determine who will ultimately lose money on the trades and how much, a handful of drillers do reveal the names of their counterparties, offering a glimpse of how the risk of falling oil prices moved through the financial system. More than a dozen energy companies say they buy hedges from their lenders, including JPMorgan, Wells Fargo, Citigroup and Bank of America.
Danielle Romero-Apsilos, a Citigroup spokeswoman, said the bank actively hedges and manages its risk. Representatives of JPMorgan, Wells Fargo and Bank of America declined to comment.
At the end of 2014, JPMorgan had about $671.5 million worth of derivatives exposure to five energy companies, including Pioneer Natural Resources Co., Concho Resources Inc., PDC Energy Inc. and Antero Resources Corp., according to company records. That’s the amount JPMorgan would have owed if the contracts were settled on 31 December, not including any offsetting trades the bank made.
It’s a similar story for Wells Fargo, which was on the hook for $460.9 million worth of oil and natural gas derivatives for companies including Carrizo Oil & Gas Inc., Pioneer, Antero, Concho and PDC, according to regulatory filings.
Energy trading
These aren’t, of course, the kind of figures that would trigger any sort of systemic-risk concerns. Commodities are generally smaller parts of banks’ businesses compared with lending and underwriting, and banks hedge their oil-price risk.
New York-based JPMorgan had $2.57 trillion in assets at the end of last year compared with net liabilities for commodity derivatives of $2.3 billion, not including cash from settled trades and physical commodity assets, according to regulatory filings. San Francisco-based Wells Fargo had $1.69 trillion in total assets compared with net commodity liabilities of $241 million.
Still, $26 billion is $26 billion.
US oil companies already netted at least $2.4 billion in the fourth quarter of 2014 on their hedges, according to data compiled on 57 US companies in the Bloomberg Intelligence index.
Oil companies would rather be losing money on the trades and making money selling crude at higher prices, Kilduff said.
“It’s like homeowners’ insurance," he said. “You don’t buy it hoping the house burns down."
Offset risk
The $26 billion of protection won’t last forever. Most hedging contracts expire this year, according to company reports. Buying new insurance today means locking in prices below $60 a barrel. The alternative is following Hamm’s example and having no cushion if crude keeps falling.
Financial institutions act as a go-between, selling oil derivatives to one company and buying from another while pocketing fees and profiting on the spread, said Charles Peabody, an analyst at Portales Partners Llc in New York. The question is whether the banks were able to adequately offset their risk when the market took a nosedive, he said.
“The banks always tell us that they try to lay off the risk," Peabody said. “I know from history and practice that it’s great in concept, but it’s hard to do in reality." Bloomberg
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