U.S. explorers still have a lot of exposure to oil and natural gas prices in 2020 as the fourth quarter nears, but if oil prices move higher as many experts are forecasting, that strategy may prove to be a winner.
The exploration and production (E&P) companies covered by Raymond James & Associates Inc. have hedged an estimated 27% of oil volumes and 16% of natural gas volumes for 2020 to date, versus current 2019 hedges on around 50% of oil and 16% of gas.
“Given our bullish oil outlook next year, we actually favor those with less hedging,” analysts John Freeman and Marshall Adkins said in a note to clients. It would appear that “the larger the company, the less oil has been hedged.”
Hedging provides some certainty for E&Ps, which is why it long has been integral to most companies’ operations. However, hedging also exposes operators to margin compression when oilfield service costs are rising.
Most of the E&Ps covered by Raymond James are materially less hedged for natural gas volumes, and the margins on oil are likely to be sharply higher.
“The average 2020 hedged gas prices are about 10% lower than 2019,” Freeman and Adkins noted. “Obviously, this lower average hedging price is due in large part to the sharp downturn we've had in the natural gas market this year,” with prices off 20% year-to-date through August.
“The abysmal realizations on hedging instruments already acquired for next year's volumes is the likely culprit behind the muted hedging of 2020 volumes we've seen so far this year, as companies are reluctant to accept such discounted prices for their gas realizations.”
Many E&Ps likely will be opportunistic with their gas hedging strategies and take a wait-and-see attitude to determine if strong winter demand will boost prices. That would be similar to what occurred in late November when gas prices approached $5, according to Raymond James.
Fitch Ratings credit analysts said gas producer hedges could help mitigate cash flow risk and support credit profiles as Henry Hub spot prices languish. Otherwise, E&Ps may need to adjust their capital spending to survive.
“In particular, natural gas-exposed E&P companies with light hedge books and those with speculative grade or low investment-grade credit profiles may be subject to refinancing and liquidity risk due to the currently depressed natural gas price environment,” the Fitch analysts said earlier this month.
In June, Fitch lowered its base-case assumption for Henry to $2.75/Mcf for 2019 and beyond because of rising production and improved Gulf Coast pipeline access, which reduced the marginal cost of supply.
Fitch’s previous gas price assumption had been $3.25/Mcf for 2019 and $3.00 for 2020 and beyond.
Narrowing Marcellus Shale differentials in recent years, however, “were supportive of realizations. The current low Henry Hub spot price environment made an effective hedge book a boon for some E&P companies with significant hedge positions.”
However, low investment-grade operators still may be susceptible to low gas and natural gas liquids prices.
Occidental Petroleum Corp., which historically has not hedged its production, is playing a different tune now that it’s acquired Anadarko Petroleum Corp. During the second quarter the Houston-based producer said it had implemented an oil hedging program for 2020 and hedged 300,000 b/d representing almost 40% of the combined company's oil production.
The last time Occidental hedged was in 2006 when it acquired Vintage Petroleum.
“With the additional leverage from the Anadarko acquisition, these new hedges will strengthen our 2020 cash flow in a low oil price environment, and provide additional assurance that our dividend is safe while we are deleveraging,” CFO Cedric Burgher told investors.
Permian Basin pure-play Pioneer Natural Resources Co., often hedged, bought more cover in the second quarter when West Texas Intermediate was around $66/bbl and Brent was close to $75.
CEO Scott Sheffield said Pioneer would add hedges “aggressively” to increase the return on capital employed. As of early August, Pioneer had hedged 72,000 b/d, or around one-third of its output through June, at $67/bbl Brent, and it plans to hedge up to half of its production.