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U.S. E&Ps Not Passing Opportunities to Hedge NatGas, Oil Volumes, Says Raymond James

An upturn in oil pricing since the start of the year has led many U.S. exploration operators to go "hog wild" in the futures market by increasing 2017 hedged oil and natural gas volumes sharply above levels at the start of this year, Raymond James & Associates said this week.

Domestic oil supplies have begun to roll over across the country and the West Texas Intermediate front month contract has appreciated by 80% since February to around $46/bbl, noted analysts John Freeman and Kevin Smith.

"After leaving $55/bbl crude futures on the table in 2015, operators are leaving nothing to chance this time around, swiping up futures contracts -- particularly collars -- to protect to the downside" at an average floor price of $47/bbl. However,  they still are participating in incremental upside through year's end and into 2017 at an average ceiling price of $60/bbl.

With improved well economics driving down drilling breakeven costs, the $49/bbl 2017 average strip could be a more attractive hedge price for exploration and production (E&P) companies than the $55 average 2016 strip level in 2015.

"We believe in the long run, minimizing cash flow volatility through hedging programs should be viewed favorably in E&P land," Freeman and Smith said. "However, it is important to note on the bullish Raymond James price deck, we see a negative impact to cash flows as a result of incremental hedging at today's futures strip...In the near term, investors must do some soul-searching to realize the full value potential in the oil patch."

The analysts acknowledged that it could be questionable to hedge as stronger oil pricing is returning. For natural gas, the current average 2017 strip is about $3.00/MMBtu today, which matches the 2016 strip during 2015.

"If our bullish commodity outlook plays out, many operators could lose their lunch money next year after locking in hedges at pricing that still has -- by our estimates -- meaningful running room before leveling off," they wrote.

There also seems to be a "large disconnect" between hedging now relative to a year ago, as companies are padding hedge books now versus deferring them in 2015. Hindsight is 20/20, however. Operators appear to be heeding the missed opportunities for 2016 to lock in 2017 cash flows.

Since oil prices peaked in 2014, there has been a remarkable improvement in the cost reductions from the wells all the way through the corporate levels too because of cost controls and efficiency measures.

"As pricing has been and continues to cross breakeven thresholds across U.S. oil basins, operators see it to be in the best interest of stakeholders to hedge production at these economic price levels through 2016 and into 2017 while the opportunity presents itself," Freeman and Smith said. "Therefore, it should come as no surprise that we have seen the accelerated hedging activity considering Permian operators largely realize 15% internal rates of return (IRR)," which is the standard industry hurdle rate, in a range of $38/bbl to $40/bbl.

Around two-thirds of core U.S. well locations achieve an IRR at $45/bbl or lower, according to Raymond James.

"As expected, we have seen much larger hedge volume additions from those non-Permian, second-tier oil basin operators." Operators not focused on Permian development have increased hedged oil volumes by 13 times since February, versus the Permian group, whose hedged oil volumes have improved by three times.

"This is a perfect illustration of the importance of crude strip pricing crossing the $40/bbl, $45/bbl, and $50/bbl thresholds for these operators that are exposed to 'lower' return basins," analysts said.

Operators are taking no chances this time around after being crushed in 2015 by "false bottoms" in the oil market.

"After having missed the chance to hedge 2016 production at $55/bbl oil and $3.00/MMBtu gas in 2015, operators are willing to take the rightfully prudent route to lock in pricing at economic levels to minimize cash flow volatility today, particularly in the case of those companies that take on significant leverage to further growth."

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