Abstract
The recent and dramatic decline in the price of oil illustrates the risk every oil and gas producer faces with energy commodity price volatility. Although depressed prices forced operators to shut-in production to save their bottom lines, companies with hedges were left in a much better position than those who had forgone 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. Luckily, 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. 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 hedge early for guaranteed revenue protection and those that hold out or hold off in hopes of a better tomorrow.
Key Points
- The primary purpose of a hedging program for upstream oil and gas is to de-risk hydrocarbon price volatility by providing a known, guaranteed revenue stream for a certain volume of oil produced. Typically entering into a hedging contract reduces the benefits of any significant upward commodity price movements, but it also protects against any dramatic price declines.
- Since October 2020, U.S. E&P companies had hedged 41% of their forecasted oil production output and 45% of anticipated gas production for 2021. The average floor for these hedges are $42 per BBL WTI and $2.58 per MMBTU Henry Hub prices.
- Price volatility in 2020 has caused many companies to protect against downside risk at the expense of potential upside gains. As of Q3 2020, the average hedge price ceiling for a majority of independent E&P companies is just above $52 per BBL. Excluding hedges made by Oxy, the average ceiling on these companies drop to $46 per BBL.
- As 2021 projections for crude price futures range between $45 to $60 per BBL, institutions issuing hedges will likely be the biggest benefactor from a bullish rally. Additional hedges may also be released following Q4 and YE 2020 fiscal reports.
- E&P companies cannot risk another year of negative cash flow if crude demand does not return, but the companies that wait a little longer to lock in hedging contracts may see the biggest gains from movements in 2021.
Introduction
The year 2020 set the stage for many changes in society moving forward and will be remembered for generations. When it comes to the oil and gas industry, the year also brought in sweeping changes. North Dakota’s State Mineral Resources Director, Lynn Helms, put it succinctly when he said, “all in all, it was a pretty terrible year for oil and gas” [14]. With depressed prices that forced operators to shut-in production to save their bottom lines, companies with hedges were left in a much better position than those who had forgone the option to reduce the impact of unanticipated price declines on revenue. With 2020 in the rear view mirror and the new year in full view, is hedging a good bet for the future? It was certainly a move that saved some companies from otherwise inevitable bankruptcies, but with the stubborn global pandemic continuing to cloud demand estimates, the future of oil prices still remains uncertain. Luckily, with upward price projections for the coming year, institutions distributing hedges to major oil companies for a portion of anticipated production may see greater benefit than recent years.
What Is Hedging?
Upstream oil and gas companies have relatively straightforward objectives: locate, develop, and extract hydrocarbons as efficiently as possible. These activities are often very capital intensive and require large amounts of cash. Therefore, companies need enough cash flow not only to support a level of capital expenditures and exploration activity to ensure reserves replacement, but also to make debt payments, comply with debt covenants, and support G&A costs [1]. Hedging programs for these upstream companies are developed with the primary purpose of providing a level of cash flow to increase the likelihood of meeting those needs. In order to understand the potential upsides and downsides to an oil and gas company hedging future production, it is important to understand the basic concept itself.
The recent and dramatic decline in the price of oil illustrates the risk every oil and gas producer has to energy commodity price volatility. In order to alleviate some risk, producers “hedge” to reduce this price exposure and transfer some or all of the risk to a party that is willing and able to assume and manage it [1]. The best way to understand hedging is to view it as a form of insurance. When a company decides to hedge, they are insuring themselves against a negative event’s impact on oil price and ultimately their finances. While the action does not protect against all negative events, the impact of a commodity’s price drop is reduced. Therefore, “hedges are a risk mitigation mechanism and are distinguishable from speculative commodity transactions in which a party assumes, rather than transfers, price risk related to a commodity in hopes that the future increase or decrease in price is in its favor and results in trading profits” [1]. Hedging is available as a crucial component of any oil and gas producer’s risk and financial management program since it helps manage the volatility of commodity markets. There are several different types of hedging transactions including over-the-counter transactions composed of swap contracts, option contracts, and fixed-price physical contracts as well as exchange-traded transactions that include futures and options contracts [2]. Additional information on types of hedging contracts is beyond the scope of this article, instead it is more important to expose the benefits of hedging activities.
Without the protection of an effective hedging program, an upstream company’s cash flows are wholly 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 2014 price downturn, and what many experienced in early March 2020. When executing a hedging program, many companies are challenged with how far out to hedge production. If prices increase over time, they largely give up that upside potential. However, if prices drop, it allows a company to weather the storm for a longer period of time. Hedging oil and gas production for months or even years into the future can be a vital tool for companies to provide certainty to their cash flow statements by potentially securing future revenues for a specific, predetermined period of time [2]. While entering into a hedging contract means that producers forgo the benefits of any significant commodity price increase, the company is simultaneously protected against a dramatic decline in prices [3]. All of these reasons have made many companies move towards the implementation of a hedging program in light of recent commodity price pressure over the last several years as a way to ensure certainty of cash flow and perhaps avoid filing bankruptcy.
Who Is Hedged?
It should become clear that the primary benefit of hedging oil and gas production is the producer’s ability to reduce the impact of unanticipated price declines on its revenue. Now it is time to investigate who has decided to hedge their 2021 production amidst an uncertain market future. At the end of October, United States E&P companies had so far hedged 41% of their total forecasted 2021 oil output at an average price floor of $42 per barrel (WTI), which is significantly lower than 2020’s floor of $56 per barrel [4]. Gas on the other was proving more resilient as more than 45% of the expected production is hedged at a Henry Hub base floor price of $2.58 per MMBtu, marginally lower than 2020’s $2.70 per MMBtu [4]. 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 [7]. Interestingly enough, only three operators – Marathon Oil, Murphy Oil, and Ovinitiv – have less than 20% of their expected 2021 oil production hedged while four others – High Point Resources, SM Energy, Parsley, and Laredo Petroleum – have above 60% of their forecast 2021 output protected [4].
Therefore, the remaining companies that have hedged volumes falling between 20-60% of their output are protected from downward price volatility but are limited from potential upward gains. Granted, as seen in Figure 1, only a select number of domestic E&P operators were investigated by Rystad Energy and had released their hedge plans prior to the report release date, so it can be expected the share of hedged 2021 oil production will grow following the release of the remaining 2020 quarterly and year end reports. It is important to note the analysis includes all contracts with full or partial floor protection: swaps, collars and three-way collars referencing different price strips converted back to WTI prices.
The 2020 oil market remained volatile through Q3 and into the new year. 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 is a strategy many brought with them into 2021. An analysis of hedging disclosures by BTU analytics over Q3 2020 filings shows that producers have downside price protection for about the same proportion of oil production in 2021 as in previous years. However, what has changed is how producers may miss out from a rapid rise in oil prices. Figure 2 shows as of early December, a group of 29 publicly traded, independent E&Ps have about 27% of their expected oil production hedged in 2021, compared to about 26% of 2020 oil production hedged as of 3Q19 [5]. A few operators like Callon, Devon, Diamondback, and Pioneer have drastically increased the percentage of expected production with downside price protection from a year ago. Some of this is driven by recent acquisitions like Devon and Pioneer adjusting hedges include existing hedges of recently acquired companies, but several others may be increasing their risk management in 2021 [7]. Occidental, on the other hand, added significant hedges this year after the closing of its Anadarko acquisition, but has yet to report any downside protections on 2021 oil production.
Why Does This Matter?
While the above figures do not fully highlight the dramatic shift in how much oil production has been hedged for 2021 so far, further investigation uncovers how some producers may miss out on any potential upswing in oil prices in the new year. This occurs because in order 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” [5]. Figure 3 shows that there is certainly downside protection for many hedges made, but current WTI prices are already bouncing around the ceiling most E&P companies have hedged on 2021 oil production.
For the sampled producers above, the average ceiling price on 2021 hedged oil volumes is $52/bbl. However, “Occidental’s call options, which it sold in order to further bolster 2020 hedges, significantly increase this average. Excluding Occidental, oil-focused E&Ps show an average ceiling of just $46.15/bbl” [5]. This means producers may sacrifice significant upside if oil prices rally in 2021, especially since (at the time of this writing) WTI prices are trading around $54/bbl [6]. For example, since SM Energy has around 70% of its expected 2021 oil production hedged, this protects the company from a significant decline in oil prices, but they also miss out on WTI prices above $40.74/bbl on a majority of its 2021 volumes. Ouch.
These projections uncover the fact that U.S. oil producers are willing to take steady income at lower, guaranteed crude prices well into next year, hedging a heavy portion of their production at around $40 a barrel in 2021. This leaves the institutions issuing hedges with potential for higher returns as the price of oil is rallying and most global analytics firms predict prices will maintain upward pressure through 2021. In fact, in the January STEO, the EIA projected 2021 Brent spot prices to average $52.70 per barrel and 2021 WTI spot prices to average $49.70/bbl [8]. Interestingly enough, in the December STEO a month prior, the EIA revealed that it saw 2021 Brent spot prices averaging $48.53/bbl and 2021 WTI spot prices averaging $45.78/bbl [8]. That is quite the jump in such a short period of time, and the EIA is not the only organization with a similar stance. Reuters released a poll of 39 economists and analysts conducted in the second half of December that forecasts Brent crude prices would average $50.67/bbl, up from a poll last month forecasting a 2021 average price of $49.35/bbl [9]. The same poll showed West Texas Intermediate crude futures are expected to average $47.45/bbl in 2021, that too is up from a November consensus of $46.40/bbl [9]. While not nearly as optimistic as the Reuters poll or the EIA, the World Bank sees spot prices hovering around $45/bbl in 2021 [10] and Deloitte sees $46/bbl [11]. Clearly the trend is for prices to start picking up momentum into 2021 but nobody has quite predicted the levels expected by ANZ Bank who released a report this past week citing their expectations of $60/bbl Brent crude for all of 2021 [12]. Currently, average 2021 U.S. crude futures have climbed above $52, also their highest since February [8]. Unfortunately, this is the precise average ceiling for 2021 hedged oil volumes in the BTU analytics sample group. With optimism growing and commodity prices rising rapidly, it will be interesting to see what other companies continue to hedge and to what extent once YE 2020 fiscal reports are released in the coming months.
Conclusion
Crude oil prices had been recovering slowly during the final quarter of 2020, and they jumped sharply earlier this month as vaccine rollouts advanced in the United States and Europe. At the same time, Saudi Arabia served a pleasant surprise to oil market participants by declaring it would cut an additional 1 million bpd from its production on top of cuts agreed with OPEC+. These actions have caused confidence for continued balancing of global oil supply and demand. As a result, U.S. crude futures this month jumped above $50 a barrel to their highest levels since February. The rally has sparked optimism among shale companies, but after a bracing year of pandemic-induced demand destruction, they are not ready to ramp up production. Why? Well, in 2020, 46 North American exploration and production companies declared bankruptcy, according to energy law firm Haynes and Boone, while several others merged to reduce debt [13]. Investors had already been pressuring shale companies to curb spending and boost returns even before the pandemic. U.S. oil production peaked at nearly 13 million barrels per day in late 2019, but is now around 11 million bpd after the coronavirus lockdowns crushed fuel demand and oil prices. Output is not expected to rise much in 2021, but companies hedged now are guaranteed revenue at a known price floor even if commodity values drop again. Therefore, there is no rush to bring significant volumes of oil back online since fears of another price crash would only make future hedging more expensive. Regardless of some price protection, many producers are still pessimistic about oil and gas futures and are satisfied with their current hedges. Others are torn between locking in new hedges at prices above anything available six months ago and missing out on the revenue from a potential bull market. 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 hedge early for guaranteed revenue protection and those that hold out or hold off in hopes of a better tomorrow.
References
[1] https://www.jw.com/wp-content/uploads/2016/03/2140-1.pdf
[2] https://blog.evaluateenergy.com/why-do-oil-and-gas-companies-hedge
[3] https://www.jdsupra.com/legalnews/were-oil-gas-producers-hedged-for-the-74503/
[5] https://btuanalytics.com/shale-production/2021-oil-hedges-missing-the-upside/
[6] https://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html
[8] https://www.rigzone.com/news/eia_raises_2021_oil_price_forecasts-13-jan-2021-164324-article/
