Oil Rally Drives Producer Hedging

A rally in oil prices that has pushed WTI spot levels above US$60 has drawn a spate of hedging activity as producers look to lock in 2016 cashflows.

California Resources Corporation, Cenovus Energy (CVE), EP Energy, EQT Corporation, Marathon Oil (MRO), Hess Corporation (HES), Gulfport Energy, and Whiting Petroleum (WLL) all initiated new hedges or added to existing hedges in the first quarter on the back of a US$10 rally from early January.

Several - most notably higher-rated firms such as Marathon and Hess - do not traditionally hedge at all, according to market participants. Most have locked in prices for future delivery at just above US$60 through to 2016 in an attempt to assure funding lines ahead of any potential summer slowdown.

"Increased hedging activity is a sign these firms view the outlook for the market as constructive enough to put down some protection - in a way it is almost a necessary pre-cursor to a pick-up in spending and/or production," said Ryan Todd, E&P equities analyst at Deutsche Bank.

"Once the value of futures contracts used for hedging moves back into a range that's reasonable, it presents an opportunity to lock in cashflow ahead of when lenders revisit the revolvers the E&P firms have in place. Having a strong outlook for the business, even if it does cap the upside, goes a long way in shoring up the risk of a lack of funding."

Futures contracts referencing the expected price of delivery in 2016 - used for hedging or as a hedging benchmark by most corporations - broke through the US$65 range in early May when spot touched US$62.

The breakthrough above these key thresholds allowed some firms to lock in future rates of sale above US$65, essentially a coup for producers wary of dips back down below US$50 that would test profitability and bring future funding capabilities into question.

Such a dip below US$50 had occurred in March, causing a similar but perhaps more frantic rush for protection (see "New oil lows revive hedging", IFR 2075 p63).

The more recent activity comes primarily from smaller firms that are prepping an eventual ramp-up in production once prices overcome weak fundamentals layered into the market through last autumn's price collapse.

"Demand is increasing, notably in gasoline, I think most of the market expects that eventually we'll break through to the upside - but in the meantime producers are taking a realistic view on the commodity," said David Leben, director in the commodity derivatives group at BNP Paribas.

"It's reflective of a move to lock in favourable economics and support the portfolio before they get ready to ramp production back up."

Not so Fast
Analysts say the activity is a positive sign for the market overall but is only one piece of the puzzle that will determine survival for more leveraged firms.

"Hedging trends overall will not have a material impact on activity levels and production trends," said Brian Gibbons, E&P analyst at CreditSights.

"Activity levels and production trends will be driven by improved economics at lower price points due to lower capital and operating costs and efficiency gains."

Investment-grade credits that hedged in the first quarter - Marathon, HESS, Devon, and Pioneer - have above average leverage for their respective credit ratings, according to Gibbons, with the exception of Pioneer, which has a massive capex programme it hopes to keep afloat.

But the rest of the high-grade market has abstained from hedging, a turnround from the days of US$100-plus prices when firms such as Anadarko, Apache and EOG Resources (EOG) were near-fully hedged.

All three let protection fall off in 2015, exhibiting a bullish directional view and balance sheet confidence that they hoped would allow them to weather dips and participate fully in upside swings.

"It is unusual to see some of these firms un-hedged, but it shows they think they have the financial wherewithal to handle the environment," said Craig Breslau, managing director in the oil trading group at Societe Generale (SGE.SG).

Bank derivative desks expect a wider range of firms to lock in future rates if WTI prices break to new highs.

"I think there is still a lot of pent-up hedging demand and if we break through new highs you're going to see a lot more firms come in. That selling pressure I think will put almost a soft cap around the US$70 level for the foreseeable future as producers take that price as soon as it hits," said Breslau.


A version of this story appears in the May 23 version of IFR magazine, a Thomson Reuters product.

(Reporting by Mike Kentz)