Hedging interest ticks up at $40 oil

NOT LONG BEFORE this issue went to press, the price of oil rose above $40/bbl. It's not a magic number. Many companies in the oil and gas space continue to falter despite the near $10/bbl increase from sub-$30/bbl in February. This column isn't about price on the surface, but about price as it relates to hedging activity.

When the price rose above $40/bbl, it triggered "renewed hedging activity from producers in the forward market," said Ole Hansen, head of commodity strategy at Saxo Bank, in a research note-a "clear indication that under-hedged US producers are willing to lock in forward prices not far from current levels."

In late January, IHS research showed that North American E&P companies hedged just 15% of their total production volumes for 2016, including 14% of oil and 18% of natural gas. Production hedging for the group of 51 companies studied will fall even more significantly in 2017, the study showed, when just 4% of total production will be hedged, including only 2% of oil and 7% of gas. In the current market of depressed prices, many companies are left largely exposed.

There are many drivers at work as companies make hedging decisions, including: fundamentals and market view, lender/investor requirements, drilling budget protection, and gut feelings (as shown in an unscientific web poll posted by Aegis Energy Risk, a Houston-based hedge advisory firm, and OGFJ one year ago). Consistency, risk reduction, and value protection are the basic goals, but there were companies that broke with the practice when prices were much higher.

Where do things stand currently? I asked Justin McCrann, president of Aegis Energy Risk, who told me that interest in hedging had, in fact, increased in March. "We began presenting hedge recommendations to clients in earnest once the market breached the $38 mark, a key resistance level," he said, noting the price represented the first "decent opportunity to place hedges since September of 2015." That being said, activity has been muted, and the reason, he offered, is three fold.

First, CAPEX budgets are very tight. As a result, four out of five producers will see "flat or declining production this year," he said, and upstream companies are "no longer dealing with perpetually higher production each month, which commanded new hedges to keep percentages in check."

Secondly, McCrann noted, "although the spot month price has rallied $14 from $26 to $40/bbl, the Cal 2017 WTI swap contract has only rallied $8, from $38 to just north of $46, and Cal 2018 up $7 from $40.50 to $47.50. This flattening of the curve (less contango) is textbook, as a commodity market works its way out of an over-supplied situation, however, it dampens the price recovery down the curve, making longer-dated hedge opportunities seem dull."

Lastly, and unfortunately for many producers, he said, "a recovery in price from $26 to $40 does not move the needle much due to high LOE costs and interest expenses. Looking at your typical upstream focused company, breakevens are well above $40/bbl."

Some activity can be linked to borrowing base uplift requirements and minimum hedge requirements surrounding acquisitions, McCrann said, which surprisingly, he noted, are becoming much more common at $40/bbl than they were at $100/bbl.

Recent activity on the hedge front includes that by Denbury Resources, Matador Resources, and Energen Corp.

Denbury now holds additional hedges for 2H16 and 1Q17. The hedges cover an average of 27,000 b/d in the third and fourth quarters at an average price of $40.66 per barrel. "While we believe oil prices will ultimately improve, we are taking steps to ensure we have liquidity and resources to weather the storm," president and CEO Phil Rykhoek noted in the company's year-end financial report.

Matador Resources added hedges in February. Based on the midpoint of its current oil guidance, the company currently has 43% of its estimated 2016 oil production hedged at weighted average floor and ceiling prices of $44 and $66 per barrel, respectively. Similarly, based on the midpoint of its current natural gas guidance, Matador has about 43% of its estimated 2016 natural gas production hedged at weighted average floor and ceiling prices of $2.61 per MMBtu and $3.54 MMBtu, respectively.

Energen updated its hedging program in early March. The company hedged an additional 5.2 MMbbls of its 2016 oil production at an average price of $41.47/bbl, bringing the company's total oil hedge position in calendar year 2016 to 6.3 MMbbls, or 50% of its oil production guidance midpoint, at an average NYMEX price of $45.33/bbl. The company also added 1.1 MMbbls of oil hedges in 2017 at an average NYMEX price of $45.05/bbl.

The uptick in hedging in recent weeks with the latest oil "rally" isn't a deluge, but there is activity. Companies are beginning to inquire, looking for some level of protection, but, said McCrann, "it will take a move into the low $50s to get the engine truly running again on hedging."