Analysis: Oil price slump sorts the hedged from the unhedged

Kodiak Energy

12/12/2014 06:00

By Lucas Iberico Lozada 
    NEW YORK, Dec 12 (Reuters) - Oil's slide to the lowest price 
in more than five years is carving a divide between U.S. shale 
drillers who heavily hedged future production and those who 
didn't. 
    While financial hedges are commonly required by many 
oilfield lenders, the industry's mid-sized U.S.-focused shale 
field producers pursued varied strategies when it came to 
protecting future revenues, according to a Reuters review of 
filings and interviews with bankers and experts. 
    Those decisions are now coming back to haunt some drillers. 
Best-known is Continental Resources  CLR.N , which lifted its 
hedges in early November, when oil was trading at around $83 a 
barrel, leaving it unprotected as prices slipped another $20, 
the most dramatic drop since the 2008 crisis. Continental's 
share price has been more than halved since late June. 
    Apache Corp  APA.N  and Whiting Petroleum  WLL.N  are also 
exposed to lower prices and have underperformed some peers over 
the past two weeks. 
    Oil producers typically hedge against lower prices by 
locking in some of their future production at favorable prices 
through swap transactions sold by banks, or by buying options as 
insurance against lower prices. 
    Among major and mid-sized exploration and production 
companies, some 35 percent of all 2014 oil production was hedged 
at an average of $95.5 a barrel as of November, according to an 
analysis prepared by RBC. Yet only 14.3 percent of 2015 
production was hedged. 
    With OPEC kingpin Saudi Arabia refusing to cut supply and 
shore up prices any time soon, firms face the prospect of lower 
revenues for months to come. U.S. crude fell below $60 a barrel 
on Thursday for the first time since 2009. 
    At Devon Energy Corp, the effect of tumbling prices "may not 
be nearly as large as you think" because of hedging, said Dave 
Hager, Devon's chief operating officer, at the CapitalOne Energy 
Conference on Wednesday. "We're in outstanding shape as a 
company." 
    Devon  DVN.N , which pumped over 80 percent of its oil from 
U.S. shale fields last quarter, stands out as the most 
aggressive hedger among the larger-cap U.S. oil drillers. It has 
hedged about 140,000 barrels per day (bpd) of crude for all of 
next year, equivalent to 80 percent of its third quarter output, 
according to company filings. 
    If U.S. crude prices were to remain at about $65 a barrel 
next year, those hedges could net Devon an extra $1.3 billion in 
revenue, according to Reuters calculations. 
    Devon has been "very good at not drinking the Kool-Aid" in 
an industry that had been counting on years of high prices, said 
Rick Rule, chairman of Sprott US Holdings, an asset management 
firm that doesn't own stock in Devon. 
     
    STEADY PACE 
    For the past several years, hedging was a relatively minor 
consideration for investors. Oil prices stayed fairly steady at 
about $100 a barrel, meaning most hedged positions were neither 
heavily in nor out of the money. 
    Now that the crude price has almost halved in the past six 
months, and predictions grow for a prolonged slump in prices, 
investors are scrutinizing filings to understand which 
corporations were clever enough to have locked in prices prior 
to the slump and therefore have enough cash on hand to pay 
increasingly expensive service contracts. 
    "The purpose of hedging is to secure cash flow regardless of 
price scenario," said Robert Campbell, head of oil products 
research at Energy Aspects in New York. "The whole thing with 
(shale drillers) is cash preservation." 
    Most large-cap producers, unlike Devon, don't hedge as a 
rule, and many such as Occidental Petroleum  OXY.N  and 
ConocoPhilips  COP.N  have even outperformed Oklahoma City-based 
Devon in recent months, aided in part by their refinery 
holdings, which generate additional revenue when oil prices are 
down. 
    Some analysts point to Apache as an example of the perils of 
not hedging. While Devon's shares have fallen by 32 percent 
since June, Apache's have dropped by 44 percent as investors 
raise alarms about a potential cash crunch. 
    "They're basically naked and don't have any cash flow 
protection," said Leo Mariani, a senior analyst at Capital 
Markets. 
     
    REVENUE VOLATILITY 
    While hedging helps producers stem losses when prices are 
low, it also caps their potential gains. Many lenders require 
their clients to place some hedges on future production in order 
to smooth out revenue volatility. 
    But others have much more flexibility. 
    Whiting Petroleum, which like its peer and rival Continental 
is heavily focused on the Bakken shale fields in North Dakota, 
had hedged only about 3,000 bpd in 2015, according to the firm's 
third-quarter SEC filings, or about four percent of its current 
daily production.  
    Its acquisition of Kodiak Energy Inc  KDKN.PK , expected to 
close early next year, will add another 6,000 barrels a day of 
hedged production through 2015, a spokesman said - still only 7 
percent of the combined company's output at current levels. 
    That may explain why Whiting's stock has fallen almost 65 
percent from all-time highs in late August, though the pending 
acquisition and its exposure to the higher-cost Bakken play are 
also likely considerations. 
 
 (Reporting By Lucas Iberico Lozada, editing by Jonathan Leff 
and John Pickering) 
 ((Lucas.Lozada@thomsonreuters.com; 646-554-6314;)) 
 
Keywords: OIL HEDGING