by Hedging is a popular trading strategy often used by oil and gas producers, airlines and other heavy consumers of energy commodities. protect against market fluctuationspp. During a decline in crude oil prices, oil producers tend to use a short hedge to lock in oil prices if they believe prices are likely to fall even lower in the future. But with oil and gas prices recently touching multi-year highs, producers who typically lock in prices are hedging very lightly or not at all to avoid leaving money on the table if crude continues to rise.
However, the failure to provide adequate protection has its downside, as a recent Standard Chartered report 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 situation, given that the latest EIA data is bearish, and the inventory shortfall relative to the five-year average is at a 15-month low.
While only a third of U.S. oil and gas companies have reported Q3 results since the Nov. 2 market open, commodities experts at Standard Chartered warn that preliminary data covering about 1 million barrels per day of crude oil production, which includes traditionally large hedgers, “their combined oil hedge book is now small, just 98MB, which is less than a fifth of the Q1-2020 peak of 563MB.
“The most striking aspect of the data is how little is hedged for 2023,” Standard Chartered notes. “In this sample, the hedging rate of companies will be only 16% next year; a year ago the ratio was 39% and in 2017 it was 81%.”
While commodity experts see the U.S. oil industry as cautious in its drilling policy and exercising strict discipline against the White House’s relentless calls to produce more, they also say risk appetite is high — it’s just shifted. Related: UAE believes oil industry in ‘decline mode’
In fact, Standard Chartered says the US oil industry has become “risk-loving in terms of the price risk it is willing to bear.”
“The lack of coverage for 2023 may be due to oil executives’ very bullish price outlook, but we believe the company’s current exposure to price impacts fits well with the message of a cautious and cautious company strategy that many recent investor calls predicted,” the report said. notes.
Source: Standard Chartered Research
Best protection: Strong balance sheet
Oil executives are betting on the best economic performance in years that high oil and gas prices are here to stay, and that optimism is reflected in lower hedging activity.
As Scotiabank analyst Paul Cheng told Bloomberg, oil and gas companies’ best defense is a strong balance sheet.
“Management teams have greater FOMO, or the fear of being hedged in a runaway market. As prices rise and corporate accounting becomes stronger than in years, many drillers abandon their usual hedging activitiesCheng told Bloomberg.
Similarly, RBC Capital Markets analyst Michael Tran told Bloomberg:Strengthened corporate balance sheets, reduced debt burden and the most constructive market outlook in years have weakened producer protection programs.“
Some major oil companies are so confident that high oil prices are here to stay that they have abandoned their hedges altogether.
Namely, Pioneer Natural Resources Co .(NYSE: PXD ), the largest oil producer in the Permian Basin, has closed almost all of its hedges for 2022 in an attempt to capture rising prices while the shale producer Antero Resources Corp.(NYSE: AR ) says it is the “least hedged” in the company’s history. Meanwhile, Devon Energy Corp. (NYSE: DVN ) is only about 20% hedged, which is significantly lower than the company’s normal ~50%.
Interestingly, some oil companies are being bullied by investors looking for more exposure to commodities.
“It has been overwhelmingly a request from 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 has told Bloomberg News when asked about the decision to hedge less.
But experts now say the current trend of not hedging future production could have significant effects up and down the futures price curve — in a good way.
This is because energy producers act as natural sellers in futures contracts approximately 12-18 months ahead. Without them, there will be less liquidity and fewer checks to trade in later months, leading to more volatility and potentially even bigger rallies. Future increases in oil prices, on the other hand, will encourage producers to invest more in drilling projects, which has slowed significantly thanks in large part to the clean energy transition.
Double-edged sword
Besides leaving money on the table, there is another good reason why producers have hedged less – avoiding potentially huge losses.
Hedging is broadly intended to protect against a sudden collapse in prices. Many producer hedges are formed by selling an above-market call option, a so-called three-way collar structure. These options are usually a relatively cheap way to hedge against price fluctuations as long as prices stay within a range. In fact, collars are inherently expensive.
In theory, hedging allows producers to lock in a certain price for their oil. The simplest way to do this is to buy the floor with a put option and offset that price by selling the ceiling with a call option. To cut costs even further, producers can sell the so-called subfloor, which is basically a put option much lower than the current oil price. This is a three-pronged protection strategy.
Three-way collars generally work well when oil prices move sideways; However, they can leave traders exposed when prices fall too far. Indeed, this strategy backfired during the last oil crash of 2014, when prices fell too low, forcing shale producers to count large losses.
But exiting hedge positions can also be expensive.
US shale producers are indeed suffering a whopping $42 billion in hedging losses in 2022with EOG Resources (NYSE: EOG ) lost $2.8 billion in one quarter Hess Corp. (NYSE: HES ) and Pioneer each paid $325 million to exit their hedge positions.
It remains to be seen whether this dramatic cut in hedging activity will come back to bite US producers.
By Alex Kimani for Oilprice.com
More top readings from Oilprice.com:
#Overconfident #Drillers #Gave #Bushes #OilPricecom
