Why Overconfident US Drillers Dropped Their Hedges | OilPrice.com

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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 fluctuationyes In times of falling crude prices, oil producers typically use a short hedge to lock in oil prices if they believe prices are likely to decline further in the future. But with oil and gas prices recently hitting multi-year highs, producers who normally lock in prices are hedging little, if at all, to avoid leaving money on the table if crude continues to rise.

However, failing to cover adequately has its drawbacks, as a recent report from Standard Chartered reveals.

According to commodity analysts, US oil and gas companies are under-hedged for 2023, leaving them with unusually high price risk. This is a risky position considering the latest EIA data is bearish, with the inventory shortfall relative to the five-year average at a 15-month low.

While only a third of US oil and gas companies reported third-quarter results as of market open Nov. 2, commodity experts at Standard Chartered caution that initial data covering roughly 1 million bpd of crude oil production, which includes the traditionally large hedgers, “their combined oil hedge book is now small at just 98mb, less than a fifth of the Q1 2020 peak of 563mb ”.

“The most surprising aspect of the data is how little is covered for 2023,” notes Standard Chartered. “Within this sample, companies have a coverage rate for the next year of only 16%; A year ago the proportion was 39% and in 2017 it was 81%.

While commodity experts say the US oil industry has become cautious in its drilling policies, maintaining strict discipline against incessant calls from the White House to produce more, they also say appetite for risk is high, it has simply moved. Related: UAE thinks oil industry is in ‘decline mode’

In fact, Standard Chartered says that the US oil industry has become “risk loving in terms of the price risk it is willing to take”.

“The lack of coverage for 2023 could be the result of an extremely bullish price outlook by oil executives, but we believe that the company’s current price exposure does not fit with the projected company’s message of cautious and cautious strategy. by many recent investor calls,” the report says. grades

Source: Standard Authoritative Research

The best coverage: a solid balance sheet

Buoyed by the best financial performance in years, oil executives are betting that high oil and gas prices are here to stay, with lower hedging activity reflecting this optimism.

As Scotiabank analyst Paul Cheng told Bloomberg, the best hedge for oil and gas companies is a strong balance sheet.

Management teams have a higher FOMO, or fear of missing out, to be protected in a market out of control. With prices on the rise and company books stronger than they have been in years, many drillers are opting out of their usual hedging activity.Cheng told Bloomberg.

Likewise, RBC Capital Markets analyst Michael Tran told Bloomberg: “Stronger corporate balance sheets, reduced debt loads and the most constructive market outlook in years have undermined producer hedging programs.

Some major oil companies are so sure that high oil prices are here to stay that they have abandoned their hedging altogether.

That is, Pioneer natural resources company (NYSE: PXD), the largest oil producer in the Permian Basin, has closed nearly all of its 2022 hedges in a bid to capture any price increases, while shale producer Antero Resources Corporation.(NYSE: AR) says it is the “least hedged” in the company’s history. In the meantime, Devon Power Corporation. (NYSE: DVN) is only 20% hedged, well below the company’s ~50% normally.

Interestingly, some oil companies are being egged on by investors seeking greater exposure to commodities.

It has been overwhelmingly the request of our investors. We have a stronger balance sheet than ever, and we have more and more investors who want exposure to commodity prices.Devon CEO Rick Muncrief told Bloomberg News when asked about the decision to cover less.

But experts now say the current trend of not hedging future production could have major implications up and down the futures price curve, in a good way.

That’s the case because power producers act as natural sellers on futures contracts 12 to 18 months ahead. Without them, trading in subsequent months has less liquidity and fewer controls, leading to more volatility and potentially even bigger spikes. In turn, higher oil prices in the future are likely to encourage producers to invest more in drilling projects, a trend that has slowed considerably thanks in large part to the clean energy transition.

double edged sword

Aside from leaving money on the table, there is another good reason producers have been hedging less, avoiding potentially huge losses.

The hedge is broadly intended to protect against a sudden collapse in prices. Many producer hedges are established by selling a call option above the market, known as a three-way collar structure. These options tend to be a relatively inexpensive way to hedge against price fluctuations, as long as prices stay within the range. In fact, the necklaces are essentially free.

In theory, the hedge allows producers to set a certain price for their oil. The easiest way to do this is by buying a bottom in price using a put option and then offsetting this cost by selling a top using a call option. To further cut costs, producers can sell what is commonly known as subsoil, which is essentially a much lower put option than current oil prices. This is the three-way neck coverage strategy.

Three-way collars tend to work well when oil prices move sideways; however, they can leave traders exposed when prices drop too low. In fact, this strategy fell out of favor during the last oil shock in 2014, when prices fell too low and shale producers posted huge losses.

But getting out of hedging positions can also be costly.

In fact, US 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 while Hess Corporation. (NYSE: HES) and Pioneer each paid $325 million to exit their hedge positions.

It remains to be seen whether this drastic cut in hedging activity will hit US producers again.

By Alex Kimani for Oilprice.com

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