Hedgeye’s Macro and Energy teams hosted a call with Wayne Penello and Andy Furman of Risked Revenue Energy Associates (“R^2”) yesterday (Wednesday, January 21st) on the risks and outlook for hedging practices in the energy space. A replay link along with a summary of the key topics of discussion is included below:
- An extended period of time with contract settlements in the $90s and $100s per barrel, along with backwardation in the forward curve created an environment where producers resisted hedging production and many were under-hedged at the mid-2014 highs in oil
- R^2 expects continued strength in the USD and oil prices that will remain low for an extended period of time with a bottom in 2016
- The most solid and well-liked companies do not have exotic hedge books and do not attempt to “time” their implementation of a hedge program. Rather they consistently hedge with straight-forward, vanilla swaps. Enhanced swaps and 3-way collars leave downside exposure and carry floating risk vs. a swap which carries fixed risk
- Example with Pioneer (weak strategy) vs. Concho (well-managed):
- Pioneer entered into enhanced swaps allowing them to swap for a higher price in the future, partially financed by selling a put below the market. They were forced to pay big premiums to buy-back this put sold when prices moved right through it
- Concho entered into plain vanilla swaps (hedged 87% in 2015 and 69% in 2016) and has significantly outperformed the XOP
- Oil collars are economically attractive to producers for the first time in ~3 years from a cap/floor price ratio. The put/call price is normally negatively skewed (put options cost more than an upside call options), but this pricing scenario has now reversed
- Volatility and credit deterioration are making it more expensive to hedge with counterparties (added premiums for worse credits and increased difficulty for counterparties to delta hedge their exposure)
- Contango in the curve right now is not generated from lack of liquidity. These back-month contracts are still active, and price discovery is real
- Small and mid-cap oil companies are hedged for 40% of production in 2015 and 20% of production for 2016 which is a real risk moving forward
- Well-hedged producers are cutting cap-ex and scaling back growth plans
- Un-hedged or under-hedged producers with too much debt will have to cut cap-ex, scale back growth plans, and will be forced into asset sales (this will accelerate when borrowing-bases are reassessed)
- Borrowing-base determinations will reset in April, and this will result in restructurings: asset sales need banks approval because assets are collateral for counterparties
- With regards to all of the paper leverage in commodity markets i.e. ETFs or leveraged futures commodity funds, some of the support for oil prices over the last week is based on the fact that many passive commodity investors had to re-weight there commodity exposure which caused another +60K long futures contracts last week (60 Million barrels of oil which is significant). The liquidation of these positions is a big risk and could be much worse than 08’.
Please feel free to reach out to us with additional questions or comments with regards to the content discussed on the call.
Ben Ryan
Analyst