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Domestic E&Ps Hedging Less Natural Gas, More Oil into 2023 – For Now
Natural gas hedging by North American producers was subdued during the third quarter while oil activity rose, despite the near-term bullish outlook for oil and the bearish forecast for gas, according to Enverus.
Each quarter the energy data consultancy reviews North American exploration and production (E&P) hedging activity to check incremental activity, valuations and implications for corporate behavior.
Enverus Intelligence Research Vice President Shawn Stuart, who co-authored the recent report, recently spoke with NGI. This year, he said, was “a really tough year from a hedging perspective.”
Indeed it was.
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Lower 48 E&Ps have lost at least $42 billion in derivatives bets this year, according to Bloomberg data, which based the estimate using 2021 hedging activity. U.S. E&Ps had hedged most of their 2022 natural gas output last year before prices began to soar, setting the sector up for one-time losses.
Hedging generally protects against a quick collapse in commodity prices. E&Ps often hedge using a call option. As long as prices are range-bound, the options basically hedge against price fluctuations.
When prices decline too much, though, traders can be exposed. For example, when oil prices began to crash in late 2014, most U.S. E&Ps ended up in the red, drawing investor scorn.
As E&Ps began to lock in 2022 hedges during 2021, many bet that oil looked better as consumer demand began to tick higher following the pandemic.
“When Covid hit, prices went down so fast that E&Ps were looking to protect their stature in 2021,” Stuart said. “But that carried on in 2022, with a lot of appetite for operators to lock in hedges.”
Hedging To Cover Capital Costs?
Still, as investors continued to call for debt reduction and slower growth, that led to reduced reinvestment rates, and with lower capital, cash flow fell.
“Hedging, obviously, takes quite a bit of a different strategy,” Stuart said. “A lot of times it was done to cover capital costs.”
E&Ps began adapting strategies and negotiating contracts for the second half of 2022 and into 2023 based on current prices. If oil prices tumble further into 2023, the more hedged E&Ps would be able to capitalize.
Enverus expects to see higher oil prices in 2023, according to a forecast issued earlier this month.
“Near-term recession concerns and oil price weakness should not obscure a tight oil supply outlook that should spark $100/bbl oil in 2023,” according to the firm. New York Mercantile Exchange natural gas, however, is expected to dip into the $3.50s by next summer.
The Energy Information Administration recently forecast U.S. gas prices to begin higher in 2023 and then decline as domestic production increases.
“We were expecting that gas producers…would definitely get hedges as we moved into 2023,” Stuart said. “But we haven’t seen it yet.”
According to NGI’s Patrick Rau, director of Strategy & Research, “Most E&Ps have been right-sizing their balance sheets these last few quarters, which has improved their leverage ratios tremendously, and that allows producers to take on more commodity risk for both oil and gas.
“By hedging more of their core oil operations, producers can more freely let their gas production ride.”
It is also difficult to receive gas outside of North America except via LNG exports. And a lot of U.S. gas produced is associated with oil drilling. The domestic liquefied natural gas market isn’t expanding until later in the decade, Stuart noted.
“So there will be more gas in North America, but nowhere for it to go.” One of the key takeaways from the Enverus report “was a surprise, as from our perspective, we’re predicting a more bullish oil price in ‘23.”
For E&Ps, it may make sense to hedge if they expect “that oil might not return to 2022 levels,” Stuart told NGI.
More Exposure To Price Upside
The Enverus report noted that increased risk tolerance by E&Ps could be “gleaned from the evolving structures of their hedge derivatives…The proportion of total hedges that are in a basic swap structure dropped from 68% in 3Q2021 to 58% in 3Q2022.”
In addition, E&Ps “are increasingly using collar-structured hedges to leave more exposure to commodity price upside.”
During 3Q2022, Enverus determined that the aggregate hedge loss had declined sequentially to $16.3 billion in net-present value (NPV) from $37 billion in 2Q2022. NPV is used as a capital budgeting technique to determine whether a long-term project may be profitable.
“This is the lowest aggregate hedge loss we have seen in over a year,” Stuart noted. Going into 2023, “I would say operators are less hedged than in 2022.”
It could be “because what happened in 2022 was a slowdown in growth and deleveraging” or it could be because there was “less desire from the operator perspective because 2022 was so bad…Nobody expected the geopolitical issues, which caused a lot of the price swing.”
E&Ps continue to have “lower debt mandates” from investors, and that has reduced the reinvestment rate. Operators also have capped their capital spending.
“Companies,” said Stuart, “are a little more cautious about growth.”
According to Rystad Energy, the U.S. E&P industry’s hedging strategy is tracked as a “critical barometer for cash flows, particularly given the sharp price volatility over the past few years, allowing investors and lenders to make funding calls.”
Some E&Ps investors don’t want money that could be lost in hedging to be left on the table.
For example, Devon Energy Corp. CEO Rick Muncrief, when asked about the decision to not hedge as much production, told Bloomberg, “It has been overwhelmingly the request of our investors. We have a stronger balance sheet than we’ve ever had, and we have more and more investors that want exposure to the commodity price.”
Those kinds of decisions are “more like a tertiary impact, with investors wanting free cash flow, which leads to low growth,” Stuart said. “With a focus on free cash flow, there is limited growth as they reduce that exposure to hedging…
“A lot of E&Ps are making money with the desire to hedge,” he said. They want to capture the protection from hedges, but “they want to protect and make money.”
In November Haynes and Boone reported that many energy banks were offering derivative products for hedging purposes.
“Higher energy prices and greater volatility may result in increased demand from energy companies for hedges,” the Haynes Boone analysts said. “However, as banks reach their hedging capacity, companies may struggle to find options within the lending group and may have to enter into swaps with third parties on both an unsecured and secured basis.
Standard Chartered found that failing to hedge adequately has a downside. If U.S. oil and gas companies remain under-hedged for 2023, it could leave them “with unusually high price risk.”
Initial data covering hedges for about 1 million b/d of crude oil output, including the “traditional” hedgers, indicated the combined oil hedge book was small.
“The most striking aspect of the data is how little is hedged for 2023,” Standard Chartered noted. “Within this sample, companies have a next-year hedge ratio of just 16%; a year ago the ratio was 39%, and in 2017 it was 81%.”
The E&P sector has become “risk-loving in terms of the price risk it is prepared to carry,” according to Standard Chartered. “The lack of hedging for 2023 could be the result of an extremely bullish price outlook by oil executives, but we think current company exposure to price sits uneasily with the message of prudent and careful company strategy projected by many recent investor calls.”
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