Oil companies got their hedges clipped4 min read . Updated: 30 Nov 2021, 05:56 PM IST
- Producers trying to lock in prices fail more often than they succeed—something to think about with prices back to multiyear highs
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Investors are demanding more from oil companies this year: More spending discipline, more cash returns, more details around energy transition strategies. They should add one more thing to the list: More humility.
After an auspicious year, a group of producers tracked by Raymond James reduced the share of production they hedged using derivatives by nearly a half for 2022 compared with this year. No wonder. With oil and natural gas prices recently hitting multiyear highs, this wasn’t a great year for energy companies to lock in the price at which they sold those commodities.
Pioneer Natural Resources, which estimated that it had made a roughly $2 billion loss through Sept. 30 due to hedges, said during an earnings call earlier this month that it will have very minimal hedging in 2022, pointing to the management’s bullish view on oil prices. Chief Operating Officer Richard Dealy said on the call that his team thinks “there’s more room to move up than down." Yet history shows that an explicit view on oil prices is exactly the wrong reason to put on or take off hedges.
There are broadly two reasons for a producer to lock in prices. One is that it is required to do so because banks won’t extend loans otherwise. Occidental, which typically hadn’t hedged in prior years, fell into this camp after its expensive Anadarko Petroleum acquisition in 2019 left it heavily leveraged. There is a reason this tends to happen with poor timing: After a year of low oil prices, energy producers tend to rack up more debt, forcing some to hedge more output the year after. In a year when prices rebound strongly (as they did in 2021), they end up forgoing a lot of revenue. But in such cases, “investors can’t get that upset for some hedge losses," noted Alex Beeker, research director at Wood Mackenzie.
Harder to justify is the kind of hedging strategy that reflects a producer’s bet on the direction of commodity prices. Companies have a poor record of predicting them.
Consider a group of oil-heavy producers that have investment grade ratings—companies that wouldn’t be forced by banks to hedge. In 2018 they increased their hedging positions to 38% of production from 34% after seeing West Texas Intermediate crude oil prices hover below $50 a barrel for a good part of 2017, according to data from Wood Mackenzie analyzed by The Wall Street Journal. When oil prices rebounded in 2018, those producers had collectively forfeited $820 million worth of revenue due to hedges, according to Wood Mackenzie estimates. This year, the same basket of companies lost out on $3 billion worth of revenue because of their decision to keep 32% of their volumes hedged.
A comparison of two companies makes a clear case for a consistent hedging strategy. From 2016 to 2021, EOG Resources’ hedging (as a percentage of production) stayed relatively constant, ranging from a low of 9% to a high of 23%. In fact, it was one of the companies with the lowest variance among those tracked by Wood Mackenzie. Pioneer Natural Resources had the highest variance (ranging from 12% to 100%). Over that period, EOG actually racked up a cumulative hedging gain of $368 million, by Wood Mackenzie estimates, whereas Pioneer Natural Resources saw $1 billion worth of hedging losses. Comparing the six years starting 2016 is a relatively balanced period because there were two “good" years (2018 and 2021) when the average WTI oil price exceeded $60 a barrel, two years when they hovered around shale producers’ average break-even price of $50 (2017 and 2019), and two “bad" ones when prices were close to $40 or below (2016 and 2020).
There are two schools of thought on how companies should hedge, according to Philip Verleger, energy economist with PKVerleger. One is to forgo hedging altogether so that the producer, over time, reaps both the benefits and losses of fluctuating commodity prices. Major oil companies, with their large balance sheets, tend to eschew hedges, letting the chips fall where they may. The second is to have a continuous hedging strategy that doesn’t stop and start based on views of the commodity market. Given the unpredictable nature of the commodity market, companies that hedge based on their views lose money over time without exception, said Paul Cheng, analyst at Scotiabank.
In its last earnings call in early November, EOG’s management noted that its hedging strategy hadn’t changed, saying that “in general, we like to have a bit of hedges put on, whether oil or gas, to just give us a little bit of line of sight into our budgeting process."
Oilmen may be good at finding crude, but not at guessing which way its price will move.
This story has been published from a wire agency feed without modifications to the text
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