By Shane Randolph and Josh Schulte
Shane Randolph
While energy markets continue to be volatile, fewer oil and gas producers have hedges in place than in prior years. In addition, a number of producers hedged with strategies containing sold puts on large portions of their production. This essentially creates a trap door where a company doesn’t have price protection below the strike price of the sold put, which for some is anything less than $45 per barrel on crude. The following is based on a survey of 30 of the largest public oil and gas exploration and production (E&P) companies and their hedging activities as disclosed in their December 31, 2019 10-K filings. It also includes comparisons to the same survey done in the prior year.
The first trading day of 2019 was the lowest daily closing price achieved by the prompt WTI futures contract in 2019 at $46.54/bbl. From there, it was a rocky ride between closing prices from around $50/bbl to $65/bbl for the remainder of the year. The crude price crash in early March 2020 that took prices down to nearly $30/bbl surprised many. Natural gas prices followed an unusual path in 2019. Early in 2019, the prompt NG futures price reached just above $3.50/MMBtu, similar to price levels in early 2018. However, the average closing price for the prompt natural gas contract during the final two months of 2019 was about $1.55/MMBtu lower than the average closing price for the final two months of 2018. Natural gas prices have dipped well below $2.00/MMBtu in early 2020.
The following survey provides as much information as possible based on information disclosed in regulatory filings. U.S. GAAP accounting rules form the minimum disclosures companies must provide in their filings to provide users with an understanding of:
· An entity’s use of hedges
· How the hedges and the hedged production are accounted for in the filing
· How the hedges affect the financial statements
While the accounting rules require entities to disclose the level of an entity’s derivative activity, there can be variance in practice as to how much information a company discloses about the instrument types, volume of production hedged and the average hedge price.
Why Hedge?
Upstream companies have relatively straightforward objectives, which are to search for, develop, and extract hydrocarbons. These activities are very
Josh Schulte
capital intensive and require large amounts of cash. Companies need enough cash flow, not only to support a level of capital expenditures and exploration activity to ensure that oil and gas continues to flow, but also to make debt payments, comply with debt covenants, and support general and administrative costs. Hedging programs at upstream companies are developed with the primary purpose of providing a level of cash flow to increase the likelihood of meeting those needs.
Without the protection of an effective hedging program, an upstream company’s cash flows are 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.
The following outlines the percentage of companies in the survey that maintained hedges as of December 31, 2019 for crude, natural gas or natural gas liquids (NGLs). Consistent with prior years, it’s clear that the majority of public oil and gas producers maintain hedging programs. However, fewer companies had hedges than in prior years. Twenty-five of the 30 upstream energy companies surveyed, or 83 percent, had hedges on the books as of December 31, 2019. This was down from 93 percent as of December 31, 2018. As of December 31, 2019, 70 percent of the surveyed companies had crude hedges in place and 60 percent had gas hedges in place.