Hedging is one way E&P companies can manage oil price risk. Hear some of the hedging strategies being used in oil and gas markets in this episode of Upstream in Perspective, featuring Paul O'Donnell from our companies and transactions team. Here is an excerpt from the podcast.

Jessica Nelson:
Paul, your team has undertaken a series of hedging studies on the North American E&Ps. What did you find to be some of the key takeaways and how widely is hedging used?

Paul O'Donnell:
In our hedging studies, we look at a group about 45 North American-based E&Ps and all but a few of these companies use at least some level of hedging. Coming into 2018, this group had hedged 36% of their estimated 2018 oil production and 41% of estimated gas production. It's also a significant portion of expected volumes that they are hedging. And, this year is actually a little higher than in prior years.

We found that the smaller companies and those with a weaker balance sheets used the most hedging. While the larger and more diversified E&Ps really used minimal hedging in the past couple of years. As an example, coming into 2018, the small and mid-sized E&P subgroups had hedged more than two-thirds of their oil production compared with just 23% for the larger E&P subgroup.

High-growth companies have also used a lot of hedging to support their increased spending levels which are driving their steep production growth targets. So, we have oil-focused companies operating in the Permian and gas-focused companies operating up in Appalachia have used more hedging to help support their more aggressive drilling plans and growth targets. This makes sense because these companies have been out-spending cash flow significantly in pursuit of that strong growth. The hedges can help them by lowering the risk behind their expected cash flows since hedges reduces their exposure to volatility in oil and gas prices. This makes our financing requirements more predictable.

One other notable takeaway from our most recent hedging study is that hedging, specifically for oil, is no longer as beneficial as it used to be. In recent years, when oil prices were falling, having hedges helped and brought in significant additional revenues for this group, but now with oil prices rising, hedges are losing money for a lot of the companies.

The group has hedged an average price of $56 per barrel at the beginning of the year, which is obviously a big discount to where current prices are.

Jessica Nelson:
Have we seen any changes in the strategies oil and gas companies have employed? And if so, what's driving those changes?

Paul O'Donnell:
We have seen changes in hedging strategies during the past year, which have been driven by a couple of different factors. The first would be the price of crude. In early 2017, prices were in the low fifties and then dropped down to the low forties by mid-year. At this level, only the companies with the lowest breakevens were willing to lock-in significant amounts of production. As a result, the lower-cost Permian companies were the most hedged.

So at mid-2017 the Permian group had hedged about 70% of their second-half oil production compared with just over 20% for the non-Permian oil-focused companies. And a lot of this has to do with where the price of oil was at that time. As prices recovered in the second-half of 2017 beyond $50 per barrel and up towards $60 by the end of the year.

Other companies outside of the Permian began to add significant amounts of hedging. At these levels, they could be profitable at a corporate level. We saw some companies focusing on other places like the Bakken and the SCOOP began to add more hedging. And then by the end of 2017 the difference had narrowed between these two groups.

A second key driver has been the growing investor emphasis on financial discipline in 2018. The market is focused on companies improving their corporate returns and spending within cash flow this year. So companies were adding hedging at the end of 2017 to lock in a price where they could balance their spending and cash flow. Therefore, achieving their goal of financial disciplined investors. Companies are now more hedged for the upcoming year than in previous years for both oil and gas.

And now, of course, these mid-$50 per barrel range hedges are actually losing money, so their turning out to be more of an impediment to cash flows rather than an aid. Nonetheless, still provide a level of safety net to price declines for the companies.

Listen to the full podcast for additional insights into hedging strategies for oil and gas companies. Or, learn more about our companies and transaction service.

Posted 18 May 2018

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.