E&P Lifeboat Hedges Fall to Lowest Rate in a Decade

Oil and gas hedges that have kept some U.S. exploration and production (E&P) companies above water during the commodity downturn will fall off at a record rate this year, according to research from analysts at Raymond James & Associates (RayJa).

At the beginning of 2015, U.S. E&P’s had hedged the price on roughly 30 percent of their oil and gas volumes. Today, the same group has hedged about 15 percent of its commodity volumes; by 2017, that’s expected to fall to 5 percent.

“This means U.S. E&P hedging is now at the lowest level seen in a decade and well below the roughly 40 percent of production that was hedged in 2014,” RayJa analysts wrote. “The lack of hedging over the past year is now being compounded (or caused) by the 2016 collapse in 2016 oil and gas futures prices.”

A company will use a “hedge” to reduce the risks associated with a volatile market. It’s based on strip pricing, which is an average of rates, usually through a 12-month period. The 2016 oil strip price is now near $38 per barrel of WTI, and the average hedged price realization for operators is a slightly higher $41 per barrel – an 8 percent premium above the strip, RayJa said. Last year’s oil price averaged $49 per barrel, while the post-hedge price was closer to $59 per barrel – a 20 percent premium.

Kevin Smith, an energy analyst at RayJa, told Rigzone there are two things – equally important – that need to happen to ultimately incentivize E&P companies to layer on more hedges: oil and gas prices need to rise to a price level that is economic for drilling, and banks will need to use price decks that are materially below strip pricing. 

“E&Ps don’t want to hedge at these levels,” he said, explaining that contracting current strip prices would lock-in uneconomic drilling rates of return. As for the banks, they have historically set their lending price decks at roughly 80 percent of strip when calculating an E&P company’s borrowing base.

“Banks can’t lend at 80 percent of strip because this would add an enormous amount of financial stress to the E&P industry and potentially send companies into bankruptcy,” he said.