Hedging is a popular trading strategy frequently used by oil and gas producers, airlines and other heavy consumers of energy commodities to protect themselves against market fluctuations. During times of falling crude prices, oil producers normally use a short hedge to lock in oil prices if they believe prices are likely to go even lower in the future.
Last year, with oil and gas prices hitting multi-year highs, producers that typically lock up prices preferred to hedge only lightly, or not at all, to avoid leaving money on the table if crude continued to soar.
But oil and gas prices have retreated significantly since peaking mid-2022, leaving producers with minimal hedging exposed to highly volatile energy markets.
Back in November, Standard Chartered reported that the U.S. oil hedge book was less than a fifth of the Q1-2020 peak of 563mb. Now the commodity traders have provided an update and revealed that producers are still showing little appetite for this type of insurance despite wild swings in oil prices. StanChart has revealed that there has been no significant rebound in oil hedging by U.S. producers over the past three months with the hedge book standing at 363 million barrels (mb) at the start of May, a mere 1.5% higher than the February estimate and the lowest across the 30 quarters of its panel survey.
Meanwhile, hedge ratios remain low with the 2023 figure at 21.2%, while the ratio for 2024 output is just 5.2%. Gas producers have been more cautious with equivalent ratios for natural gas output at 43.2% for 2023 and 22.5% for 2024, perfectly understandable considering the huge gas price crash. The experts have reported that the distribution of 2023 purchased put options held by producers is mostly clustered almost exactly in the middle of the key USD 68-72/bbl range, suggesting that gamma effects are likely to intensify the next significant move above or below that range.
About a month ago, Standard Chartered reported that the extreme volatility being witnessed in the oil markets is due to gamma hedging effects, with banks selling oil to manage their side of options as prices fall through the strike prices of oil producers put options and volatility increases. The negative price effect has been exacerbated because the main cliff-face of producer puts currently occupies a narrow price range. While gamma hedging effects do not trigger the initial price fall, they result in a short-term undershoot, further magnified by the closing out of associated less committed speculative longs.
The Best Hedge: A Strong Balance Sheet
Buoyed by the best financial performance in years, oil executives are wagering that high oil and gas prices are here to stay, with less hedging activity reflecting this optimism.
As Paul Cheng, an analyst at Scotiabank, has told Bloomberg, the best hedge for oil and gas companies is a strong balance sheet.
“Management teams have greater FOMO, or fear of missing out, being hedged in a runaway market. With prices rising and companies’ books stronger than they’ve been in years, many drillers are opting out of their usual hedging activity”, Cheng told Bloomberg.
Likewise, RBC Capital Markets analyst Michael Tran told Bloomberg, “Fortified corporate balance sheets, reduced debt burdens and the most constructive market outlook in years has sapped producer hedging programs.”
Some Big Oil companies are so confident that high oil prices are here to stay that they have completely ditched their hedges.
To wit, Pioneer Natural Resources Co .(NYSE: PXD), the biggest oil producer in the Permian Basin, closed out almost all of its hedges for 2022 in a bid to capture any run-up in prices while shale producer Antero Resources Corp.(NYSE: AR) revealed that it’s the “least hedged” in the company’s history. Meanwhile, Devon Energy Corp. (NYSE: DVN) is only about 20% hedged, way lower than the company’s ~50% normally.
Interestingly, some oil companies are being egged on by investors looking for more commodity exposure.
“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,” Devon Chief Executive Officer Rick Muncrief told Bloomberg News when asked about the decision to hedge less.
But the experts are now saying that the current trend of not hedging future output could have major implications up and down the forward price curve–in a good way.
That’s the case because energy producers act as natural sellers in futures contracts some 12 to 18 months ahead. Without them, trading in later months has less liquidity and fewer checks, leading to more volatility and potentially even bigger rallies. In turn, higher oil prices in the future are likely to encourage producers to invest more in drilling projects, a trend that has slowed down considerably thanks in large part to the clean energy transition.
Other than avoiding leaving money on the table, there’s another good reason why producers have been hedging less–avoiding potentially huge losses.
Hedging is broadly meant to protect against a sudden collapse in prices. Many producer hedges are set up by selling a call option above the market, a so-called three-way collar structure. These options tend to be a relatively cheap way to hedge against price fluctuations as long as prices remain range bound. Indeed, collars are essentially costless.
In theory, hedging allows producers to lock-in a certain price for their oil. The simplest way to do this is by buying a floor on the price using a put option then offsetting this cost by selling a ceiling using a call option. To trim costs even further, producers can sell what is commonly referred to as a subfloor, which is essentially a put option much lower than current oil prices. This is the three-way collar hedging strategy.
Three-way collars tend to work well when oil prices are moving sideways; however, they can leave traders exposed when prices fall too much. Indeed, this strategy fell out of favor during the last oil crash of 2014 when prices fell too low leaving shale producers counting heavy losses.
But exiting hedging positions can also be costly.
Indeed, U.S. shale producers suffered tens of billions in hedging losses in 2022, with EOG Resources (NYSE: EOG) losing $2.8 billion in a single quarter while Hess Corp. (NYSE: HES) and Pioneer paid $325M apiece to exit their hedging positions.
Whether or not this dramatic cut in hedging activity will come back to bite U.S. producers remains to be seen.
By Alex Kimani for Oilprice.com