Oil and gas companies continued to hedge ahead of price spikes | Timely LLP
The following is a survey of the 30 largest public E&P companies and their hedging activities as disclosed in their filings on December 31, 202110-K. It also includes comparisons with the same survey conducted the previous year.
The following survey provides as much information as possible based on what has been disclosed in regulatory filings. US GAAP accounting rules constitute the minimum information that companies must provide in their documents to enable users to understand:
- Use of hedges by an entity.
- How coverages and covered production are accounted for in the file.
- How hedges affect financial statements.
Although accounting rules require entities to disclose the level of an entity’s derivative activity, there may be variances in practice as to how much information a company discloses about types of instruments, the production volume covered and the average price of the cover.
Upstream oil and gas companies have relatively simple objectives, which are to research, develop and extract hydrocarbons. These activities are capital intensive and require large amounts of cash. Companies need sufficient cash flow not only to support a level of capital expenditure and exploration activities to ensure that oil and gas continues to flow, but also to make the payments. debt, comply with debt covenants and cover general and administrative costs. Upstream company hedging programs are developed with the primary purpose of providing a level of cash flow to increase the likelihood of meeting these needs.
Without the protection of an effective hedging program, an upstream company’s cash flows are subject to market volatility. An upstream business without hedging will benefit from higher market prices, but may need to adjust its trades when market prices fall for an extended period.
The following table shows the percentage of companies in the survey that maintained hedges as of December 31, 2021 for crude oil, natural gas or natural gas liquids (NGLs). Consistent with previous years, it is clear that the majority of public oil and gas producers maintain hedging programs.
Companies that had hedges
Twenty-six of the 30 upstream energy companies surveyed, or 87%, had hedges on the books as of December 31, 2021. This figure is similar to the 90% figure as of December 31, 2020 and matches most survey results from the ‘last year. By the end of 2021, 73% of companies surveyed had crude oil hedges in place and 73% had gas hedges in place.
Investors should carefully consider the types of instruments used in their hedging program. Hedging strategies can provide different levels of downside protection depending on the mix of hedging instruments used. The following table shows the number of companies holding various types of instruments in their cover pool.
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For a producer, swaps offer the most downside protection. However, swaps limit participation in rising prices. This leads producers to use purchased put options, which can be expensive, or costless collars, which allow the producer to participate in a range of price movements. Other instruments noted in the survey were swaptions and three-way options. Swaptions, often used to increase a strike price by allowing a counterparty to increase the volume or lengthen the duration of the contract at its discretion, continue to represent a minority of the types of instruments used by public companies. Three-way options (sometimes referred to as three-way necks) are also used to increase the strike price participation window between the bought put option and the sold call which typically overlaps current market prices in the strategy cost-free collar using the premium received from selling a put below current market prices. This strategy can backfire if market prices fall below the sold put.
Among the public oil and gas companies reviewed, swaps continue to be the preferred instrument for natural gas and crude oil. A strategy using both swaps and collars was common for raw gas and natural gas, which is generally consistent with the prior year.
Duration of cover
When running a hedging program, many companies face the challenge of how far to hedge their production. If prices rise over time, they largely forgo the upside. However, if prices fall, it allows the company to weather the storm longer. Based on the survey results, it is common for companies to hedge some level of the fast 12-month period representing 2022. About half of companies with crude oil or gas hedges held hedges in 2023 as of December 31, 2021. Similar to last year, only a handful of companies held crude hedges in 2024 (over 36 months). More companies held gas hedges in the two- to four-year range as of December 31, 2021 than the previous year.
As a hedging program aims to increase cash flow predictability, the price level at which companies execute hedges is often heavily influenced by operating budgets and debt compliance.
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For companies that disclosed their average floor prices for WTI Cushing crude, Henry Hub natural gas, or both, the average swap price for crude was $54.17/bbl for 2022 and $56.16 /bbl for 2023 and natural gas was $2.95/MMBtu for 2022 and $2.94/MMBtu for 2023. The average (non-triple) sale price of crude was $51.60/bbl for 2022 and $51.29/bbl for 2023 and natural gas was $2.94/MMBtu for 2022 and $2.91/MMBtu for 2023.
Consistent with the previous year’s survey, few companies disclosed the amount of their planned production that was covered as of December 31, 2021. Only six companies disclosed a percentage of planned production covered. For the companies that disclosed this information, the average coverage level for crude was 51% of forecast 2022 production, and for natural gas was 54% of forecast 2022 production. Note that these coverage levels include coverage provided by three-way options.
In summary, having an effective hedging program in place can be a tool to provide cash flow certainty and provide a longer reaction time in the event of a market price crash. Management teams are encouraged to consider the various alternatives and hedging strategies available to them.