Any expectations that oil prices could be heading back up following a 10% bounce at the start of February were quickly dashed last week as WTI spot prices slumped to new lows, closing at US$43.39 on Tuesday.
The latest decline comes as a response to fundamental over-supply issues that have still not been addressed. Many believe that prices could fall further, adding to the heightened volatility that has triggered a renewed interest in commodity derivatives for hedging and investment purposes.
“We’ve seen a complete reversal of the benign environment where there was limited hedging and investing,” said Jonathan Whitehead, head of commodities at Societe Generale. “Some producers are now under severe pressure and some will struggle to keep going, so hedging is back on the agenda and volatility is attracting investors back to the sector.”
Many of the larger producers with strong balance sheets choose not to hedge their future production. But for smaller firms, access to reserve-based lending is typically conditional on strong risk management policies.
Now, with prices dropping dangerously close to, or even below, the cost of production for an increasing number of firms, access to such funding could prove crucial for survival. But some could find the funding door has closed after widespread restructuring and monetization of hedge positions delivers a broad array of outcomes.
“Many E&P firms are looking at financial optimization and rebalancing their debt, future investment and hedging activities. If you are massively in-the-money on your hedges, it might make sense to reset strikes and pay down debt, particularly if you are paying off some of the covenants that are more restrictive,” said Whitehead.
Some, however, are feeling the pain from having made the move too early. Continental Resources, for example, sold some of its hedge book during the third quarter of last year for proceeds of US$433m as the firm took a bet on a sharp recovery as it cashed in its right to sell future production at around US$90 a barrel.
“Some producers took their hedges off towards the end of last year but the market has proved them wrong. If prices had rebounded, they would have been heroes, but many got out about US$30 above where we are now,” said Nabil Naccoul, head of oil trading at Citigroup.
“Instead of hedging at US$100, many are now hedged at US$70, which probably isn’t that bad, but they can’t sustain those levels when the cash runs out.”
Continental Resources’ derivatives gains represented just under 10% of its US$4.6bn capex budget for 2014. Capex has been slashed to US$2.7bn for 2015 from an earlier slated US$5bn as a direct response to low oil prices. And the pain has been felt in the firm’s share price, which currently trades at just half of its September 2014 highs.
Timing it right can be transformational for a highly leveraged firm, with dealers noting exceptional occasions where smaller producers have been able to pay off all of their debt as the result of a hedge restructuring.
The benefits can be significant. Linn Energy reported fourth-quarter gains of US$1.2bn on unsettled derivatives contracts in 2014, compared with a loss of US$44m on hedges for the same period a year previously.
CONTANGO EFFECT
Linn’s derivatives gains, which exceed its entire US$730m capex program for 2015 (reduced from US$1.55bn for 2014) were buoyed by the firm’s tendency to hedge at the back end of the curve, which is currently in steep contango, with longer maturities equating to higher prices. ICE-listed front month WTI futures currently trade at US$46, while September contracts are quoted around US$52.
Although not a common strategy for producers, back-end hedging can provide an accounting benefit. And as the curve moved into steep contango, driving up the cost of longer-dated exposures, Linn reaped the benefit of its longer-dated and higher-valued hedges.
The phenomenon is driving other producers to longer-dated hedging strategies as the rising cost of rolling into next-month futures makes traditional quarterly strategies unattractive.
“Given the contango, those who hedged the calendar year have done better. Producers are doing more calendar hedging and right now as hedging the front doesn’t make any sense because of the shape of the curve,” said Naccoul. “If you’re confident that current prices and the shape of the curve are here to stay, then it makes sense to hedge at these levels.”
OPPORTUNISTIC CONSUMERS
For consumers, the first quarter was marked by an early flurry of activity, particularly from airlines locking in six-year lows – some of which sought board approval to expand their hedging remit.
“It’s a great environment for consumers,” said SG’s Whitehead. “Consumers typically have narrow pre-agreed risk management remits, but have extended their hedging activities by amount and tenor. Many are pushing hedges out to five years, and that’s pretty unusual.”
Beyond the largest users, however, hedging has been opportunistic rather than widespread. Analysts at Citi believe that there could be further to fall and see US$20 as a floor.
“Consumer hedging activity slowed a lot after 2008, but we’ve seen more recently. A lot had hedged around US$100 and with the market now at US$50 they should perhaps be doing more, but they tend to take a more opportunistic approach to hedging especially in a contango market,” said Naccoul.