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Producers turn to hedging as shelter against oil market turmoil

Highlights

Pioneer bets on Q2 Brent prices to get cash uplift

Laredo has 100% of 2020 oil production hedged

Husky won't hedge in current 'train wreck' market

Houston — US shale oil producers have moved in droves during the last couple of months to protect themselves from current market turmoil by hedging, using a variety of derivative instruments to protect against exposure to volatile oil prices.

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As crude prices plunged from low demand as the coronavirus pandemic ravaged the globe, producers cut 2020 capital budgets in half and released huge numbers of drilling rigs. They also shut-in their lower-margin production.

Many also used a variety of contractual arrangements to assure their oil and gas output – and therefore, their revenues –weren't roughed up too badly during a period of dismally low oil prices and near-term cloudy visibility.

"They want to be able to stop the bleeding" or at least minimize it, Thomas Watters, a managing director at S&P Global Ratings, said.

After the end of the first quarter, upstream operators hedged their 2020 estimated oil production at the highest levels in at least five years, investment bank Goldman Sachs said in a recent investor note.

The producers Goldman Sachs covers have hedged 66% of their projected oil production for the rest of this year, a "sharp increase in oil hedged," which was 48% pre-downturn, the bank said.

Also, "we saw a sharp pick-up in 2021 hedging for oil and natural gas," Goldman Sachs said. "Producers have 14% of 2021 estimated oil production hedged (versus 2% post Q4 2019 earnings) and 28% of 2021 estimated gas production hedged (versus 15% post Q4 2019 earnings)."

That puts 2021 hedging at slightly above-average levels seasonally for liquids and above-average levels seasonally for gas, said Goldman Sachs, adding that as of Wednesday, current hedged 2020 oil prices of $44.19/b, assuming roughly $31.77/b WTI for collars, were "well above" strip prices of $33.57/b.

PIONEER ENHANCES OUTPUT PRODUCTION IN Q2

Pioneer Natural Resources, a large Permian Basin producer, said early in April that it enhanced protection of its output through derivative positions for Q2 – forecast as the most volatile for oil prices – with an assortment of swaps and collars.

Those positions would provide a forecasted cash uplift to Pioneer of around $280 million if Brent prices averaged $25/b during the quarter.

What that basically means, according to Shane Randolph, managing director at energy financial services firm Opportune, is that if prices rise, Pioneer "would make less money (or lose money) on the hedges depending on the instruments, and they would make more money on the physical commodity."

As of May 29, ICE front-month Brent has averaged $29.57/b in Q2.

A swap is an agreement whereby a "floating" (i.e., market) price is exchanged for a fixed price over a specified time period. Collars protect against downside risks while maintaining some exposure to upside prices.

Pioneer has historically hedged a large chunk of its oil output, which is currently over 220,000 b/d. That has cushioned the company against price crashes and allowed double-digit percentage oil output growth in recent years.

Pioneer also has 135,000 b/d of oil production protected at $43/b Brent with upside for 2021, company officials said.

Midsized Permian Basin producer Laredo Petroleum said 100% of its oil output for 2020, or about 7.178 million barrels (30,700 b/d) is hedged, as is 5.603 million barrels (15,350 b/d) for 2021 so far.

Laredo produced 29,200 b/d of oil in Q1 and expects to average 26,000-27,000 b/d of output for 2020, including about 30,000 b/d in Q2.

Laredo "significantly" added to its 2021 hedges in recent months, CFO Michael Beyer said. Added were 8,750 b/d of Brent-linked hedges -- 6,750 b/d of puts and 2,000 b/d of swaps.

Laredo bought the hedges with $50 million of expected free cash flow this year, resulting in a total 2021 Brent hedge position at a weighted average floor price of roughly $53/b, Beyer said.

"[That move] secures significant cash flows in 2021, supporting a potential capital program that could keep average daily oil production in 2021 flat with the fourth-quarter 2020 exit rate while generating free cash flow" at WTI prices of $30/b to $35/b, he added.

EOG HEDGED HEAVILY IN Q2-Q3

EOG Resources, a large operator which historically hasn't been a large hedger, nonetheless did so as oil headed south over the last few months.

The company has now hedged more than 95% of its Q2 2020 oil production at an average price of $48/b and more than 50% of its Q3 output at $47/b.

"This mirrors how we view the periods of greatest price risk," Tim Driggers, EOG's chief financial officer, said on its Q1 call. "We will begin to look at adding additional 2021 hedges later in the year if prices look attractive."

Midsized Parsley Energy also restructured existing 2020 hedge positions to secure cash flows and protect not only its 127,000 b/d of output for this year but even 2021 production, CEO Matt Gallagher said.

"Over 80% of our hedges in the second quarter are [now] swaps or two-way collars with unlimited downside protection," Gallagher said.

Also, Parsley moved "aggressively" to protect 2021 cash flow by adding swaps, he said: "[Those are] well in the money based on today's strip," he said.

The company now expects net settlement gains of nearly $650 million during second-quarter 2020 through fourth-quarter 2021 under a go-forward $30 WTI oil price and current basis differentials, company officials said.

That is an increase of over $350 million in total downside protection from its hedge position as of February 19.

Among a handful of non-hedgers is Canada's Husky Energy. Rob Peabody, Husky's CEO, doesn't think it is wise to lock in futures prices amid what he called a "train wreck" market of severe oil price volatility.

But Husky, which has refining assets, is different from independent oil companies since it can run its oil through its own facilities, which cushions it some against price turbulence.

"Our investments have really been focused on that to get us to where we're breakeven ... sort of in the mid-$30/bs now on a cash basis," Peabody said. "That feels in a pretty good place," he said.