Hedging is the biggest double edge sword in the energy business. A hedge program can save your company, or destroy it. ‘Destroy’ may be a bit dramatic, but it nearly happened to a small Canadian producer a few years ago that locked in too much production at a low price, only to have to pay government royalties at an astronomical rate when natural gas prices skyrocketed.
From one perspective, hedging means you will always be wrong; if prices go down, not enough was hedged, and if they go up, too much was. Hedging will make you look like a hero or an idiot. But those outcomes can still happen even if you don’t hedge at all. And the worst of it is that it’s very hard psychologically to hedge in a falling price environment, which is exactly when it’s needed most.
One argument against hedging is that investors buy oil and gas stocks for potential share appreciation when commodity prices shoot up. There is some validity to that argument; however the trick is to not get hit by a truck when you’re waiting for that to happen. And as we enter 2016, there are a lot of procrastinating hedgers embedded in truck grills.
Without a systematic rolling hedging program, it’s very difficult to pick the right time to enter the market. Earlier in 2015, with prices falling, a common consensus was that prices would soon bounce back, or at least stabilize, so there was no rush to hedge. In mid summer, oil prices did rebound, which seemed to bear out that hypothesis. But they never bounced back all that much, so most potential hedgers stood on the sidelines. Hedges that were rolling off from the prior year were $80-90, so why jump at $60 when the market was recovering?
The answer is (with hindsight, of course) that $60 was way better than the $50 available now. Six months later, a $60 hedge is a distant dream. So the dilemma arises again, except that the deciding factor at this stage of the cycle might be one of survival rather than profit maximization. To lock in at today’s price might help ensure that a company stays alive until 2017, but there is a cost to that – survival mode means pared down operations, little capital spending, probably declining production, and therefore a deep hole to climb out of. A big consideration also is foregone upside if commodity prices do bounce back strongly; the world is only one Middle East conflict away from a potential supply shock and sharply higher prices. No public-company CEO wants to see their shares underperform the market if a strong price rebound occurs, which is why there are companies out there right now staring the grim reaper in the face, without hedges, and with no plan to add some. As illogical as that sounds, it is a reality for public companies if they’ve chosen to market themselves as those likely to benefit most from a commodity price revival.
Obviously hedging isn’t all or nothing, so the best alternative is to hedge a reasonable portion of production, or maybe a small portion to start, and then build on that as the market allows. The market hasn’t allowed much in the third and fourth quarters; each day was gloomier than the one past. The last week or two have however seen a tiny little bounce in oil and gas prices, which is like being in a life raft for 9 months and finally seeing a piece of driftwood. Not much, but you paddle like hell to get it. For this holiday season, there is now a rush to lock in 2016 prices on the weakest of pricing rebounds because the past few months have brought both oil and natural gas prices to such lows that few companies can make money at these levels. Hedging now, even at such low forward strip prices, may mean the difference between bankruptcy and living to fight another day.
Incidentally, isn’t it interesting that some OPEC members are surprisingly quiet given that their lifeblood – oil revenues – have been decimated. For years OPEC preached price stability as a goal, first declaring $75 was a reasonable price, then $100. And we all believed them. Then, OPEC embarked on their brave new path in late 2014, when oil prices were above $90/barrel, and the message shifted 180 degrees in a single day. Oil prices were now free to fall as far as they wanted, OPEC declared, the goal was now to protect market share. If you were an OPEC member and were privy to this policy change, would the thought of placing a few bets in the futures/options markets maybe cross your mind?
But that’s neither here nor there. It is unlikely to ever know what goes on in that realm. If your company enters 2016 relatively unhedged, you can at least keep this pleasant thought in mind – the banks aren’t remotely interested in operating your assets, so offering them the keys to the shop will be like handing garlic to a vampire. On that note, happy holidays!
Read more insightful analysis from Terry Etam here