Hedging is a popular trading strategy frequently used by oil and gas producers, airlines and other large consumers of energy commodities to hedge against market fluctuationss. During periods of declining crude prices, oil producers normally use a short hedge to lock in oil prices if they believe prices are likely to fall further in the future. But with oil and gas prices hitting multi-year highs recently, producers who typically lock in prices hedge very lightly, if at all, to avoid leaving money on the table if crude continues to soar. .
However, not covering yourself adequately has its downsides, as a recent report from Standard Chartered reveals.
Commodity analysts say U.S. oil and gas companies are underhedged for 2023, exposing them to unusually high price risk. This is a risky position considering that the latest EIA data is bearish, with the inventory shortfall to the five-year average at a 15-month low.
With only a third of U.S. oil and gas companies reporting their third quarter results when the market opened on Nov. 2, commodities experts at Standard Chartered warn that initial data covering around 1 million bpd of production oil hedgers, which include large traditional hedgers, “their combined oil hedging book is now small at just 98MB, less than a fifth of the Q1-2020 peak of 563MB.”
“The most striking aspect of the data is the little coverage for 2023,” notes Standard Chartered. “Within this sample, the companies have a coverage ratio for the following year of only 16%; a year ago the ratio was 39% and in 2017 it was 81%.
While commodity experts consider the US oil industry has become cautious in its drilling policies, maintaining strict discipline against the White House’s relentless calls for more production, they also say risk appetite is high – it just changed. Related: UAE thinks oil industry is in ‘decline mode’
In fact, Standard Chartered claims that the US oil industry has become “risk addicted in terms of the price risk it is willing to bear”.
“The lack of hedging for 2023 could be the result of an extremely bullish price outlook from oil executives, but we believe companies’ current price exposure does not align with the message of a hedging strategy. cautious and prudent business projected by many recent calls from investors,” the report said. Remarks.
Source: Standard Accredited Research
The best hedge: a strong balance sheet
Buoyed by the best financial performance in years, oil executives are betting high oil and gas prices are here to stay, with less hedging activity reflecting that optimism.
As Scotiabank analyst Paul Cheng told Bloomberg, the best hedge for oil and gas companies is a strong balance sheet.
“Management teams have greater FOMO, or fear of missing out, being hedged in a runaway market. With prices rising and company books stronger than they have been in years, many drillers are forgoing their usual hedging business.,” Cheng told Bloomberg.
Similarly, RBC Capital Markets analyst Michael Tran told Bloomberg:Strengthened corporate balance sheets, reduced debt burdens and the most positive market outlook in years have undermined producers’ hedging programs.”
Some major oil companies are so convinced that high oil prices are here to stay that they have completely abandoned their hedges.
to witness it, Pioneer Natural Resources Co. .(NYSE:PXD), the largest oil producer in the Permian Basin, has closed nearly all of its hedges for 2022 in a bid to capture any price increases as the shale producer Antero Resources Corp..(NYSE: AR) says it’s the “least covered” in the company’s history. Meanwhile, Devon Energy Corporation. (NYSE: DVN) is only about 20% hedged, well below the company’s normal ~50%.
Interestingly, some oil companies are encouraged by investors looking for more commodity exposure.
“This was massively requested by our investors. We have a stronger balance sheet than ever and we have more and more investors who want exposure to commodity pricesDevon CEO Rick Muncrief told Bloomberg News when asked about the decision to cover less.
But experts are now saying that the current trend of not hedging future production could have major implications up and down the futures price curve – in a good way.
This is the case because energy producers act as natural sellers in futures contracts 12 to 18 months ahead. Without them, subsequent months’ trades have less cash and fewer checks, leading to more volatility and potentially even bigger rallies. In turn, higher oil prices in the future should encourage producers to invest more in drilling projects, a trend that had slowed considerably thanks in large part to the transition to clean energy.
Double edged sword
Besides leaving money on the table, there’s another good reason why producers hedged less – avoiding potentially huge losses.
Hedging is usually meant to protect against a sudden price crash. Many producer hedges are set up by selling a call option above the market, a so-called three-way tunnel structure. These options tend to be a relatively cheap way to hedge against price swings as long as prices remain constrained. Indeed, the collars are essentially free.
In theory, hedging allows producers to lock in a certain price for their oil. The easiest way to do this is to buy a floor on the price using a put option and then offset that cost by selling a ceiling using a call option. To further reduce costs, producers can sell what is commonly referred to as a subfloor, which is essentially a put option well below current oil prices. This is the three-way collar hedging strategy.
Three-way collars tend to work well when oil prices move sideways; however, they can expose traders when prices drop too much. Indeed, this strategy fell out of favor during the last oil crash of 2014 when prices fell too low, leaving shale producers to count heavy losses.
But exiting hedge positions can also be costly.
Indeed, American shale producers will suffer a staggering $42 billion in coverage losses in 2022with EOG Resources (NYSE: EOG) losing $2.8 billion in a single quarter as Hess Corp. (NYSE: HES) and Pioneer each paid $325 million to exit their hedge positions.
Whether or not this dramatic reduction in hedging activity will come back to bite US producers remains to be seen.
By Alex Kimani for Oilprice.com
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