Oil Lifeline Turns Into $7 Billion Drag as Crude Prices Jump

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(Bloomberg) -- There’s a downside to oil prices being up that could cost the industry more than $7 billion.

When crude markets slumped, explorers used hedging contracts to lock in payments for future barrels to ride out prices that fell as low as $27 a barrel in 2016. Now, as global tensions and OPEC supply cuts drive prices toward $70 in New York, those financial insurance policies have become a drag on profits, limiting some companies from cashing in on the rally.

Hess Corp. last week said it had paid $50 million to unwind hedges that capped its sales at $65 a barrel, even as U.S. benchmark prices surged above that. It’s likely to have company, said Andrew McConn, an analyst at Wood Mackenzie Ltd. If crude stabilizes at around $68 a barrel this year, McConn estimates top producers will lose $7 billion on their hedging contracts in 2018.

“The sector is much more hedged in terms of volumes than it has been in the past," McConn, who is based in Houston, said in an interview. “Basically every company is going to lose a significant amount of upside exposure if prices stay where they are now."

To be sure, hedging generated about $23 billion in gains for those same companies from 2015 to 2017, when oil nosedived from near $100 a barrel to almost $20, according to Wood Mackenzie. And producers are still benefiting from today’s rally, with wells in some U.S. shale plays that can make money at levels well below current hedging prices.

Most companies, on average, are hedging about 30 percent of their output, leaving plenty of barrels to sell at full-market price, according to Wood Mackenzie.

But for investors looking to make the most out of crude’s rebound, hedging’s now a complication, not a lifeline. Among 33 companies McConn analyzed -- a group including Hess, Anadarko Petroleum Corp., Pioneer Natural Resources Co. and EOG Resources Inc. -- just three had hedging programs expected to increase 2018 revenue by more than 1 percent; eight have programs expected to generate losses.

Companies could bypass hedging limits by pumping out additional barrels that they can sell at market rates, said Daniel McLaughlin, an oil analyst at Bloomberg New Energy Finance in New York. But that’s a fraught strategy, he said, at a time when investors are demanding spending restraint and shale drillers are already struggling with shortages in labor and pipeline capacity.

Hess, for its part, has hedged about 42 million barrels of production this year with instruments called two-way collars, according to a BNEF database of hedging activity. The agreements set a floor of $50 a barrel and a ceiling of $65. Hess bought out the upper limit “in hopes that the prices remain high enough to not only pay back the $50 million but also capitalize further without the ceiling," McLaughlin said.

Renegotiating hedges can involve “pretty complex" talks between producers and counterparties holding the contracts, said McConn. “A lot of it depends on what price you paid and a company’s internal house view where prices are going," he said. But explorers may find it’s the least painful alternative.

©2018 Bloomberg L.P.

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