March 13, 2020 / 2:28 PM / 21 days ago

UPDATE 3-U.S. shale companies hedges were inadequate for oil price crash

 (Adds closing prices, detail on Apache)
    By Devika  Krishna Kumar and Liz Hampton
    NEW YORK/DENVER, March 13 (Reuters) - Oil prices have
plunged so much that even U.S. shale producers who have paid for
the industry's version of income insurance must deal with big
holes in their budgets.
    Crude oil prices have crashed about 50% this year, hit by
the coronavirus outbreak and the surprise price war that erupted
last weekend between Saudi Arabia and Russia. The U.S. crude
benchmark        on Friday posted its worst week since the 2008
global financial crisis and closed at $31.73 a barrel, far below
the $50-per-barrel price where many companies hedged.      
    With prices at three-year lows, shale producers also are
exposed because they used options in such a way that their
insurance erodes the more oil declines. 
    "U.S. production is likely less well hedged than the market
realizes," said Michael Tran, managing director of energy
strategy at RBC Capital Markets in New York.
    (Graphic link: )
    Shale companies protect their revenues with hedges because
oil prices can swing wildly due to unforeseen events. About 43%
of 2020's oil production was hedged as of the end of the fourth
quarter, according to Goldman Sachs. 
    But that 43% is not fully covered. Producers use a variety
of methods to hedge production. The simplest is to purchase a
put option that allows the holder to sell at a fixed price at a
particular time, regardless of where oil prices are trading.
That locks in a selling price of, say, $50 a barrel.
    Many shale producers used a more complex strategy, known as
three-way collars. Producers still buy the put options as
insurance, but they also sell other put options, often with a
lower price point - to lower or eliminate the cost of their
     Effectively, this is a calculated bet that oil will fall to
a certain level and no further. But that was not what happened. 
    "Using many of these structures, producers are
price-protected unless prices fall below a certain threshold,
and $45 a barrel was a popular strike level, at which point
producers become fully exposed," Tran said.
    RBC Capital Markets equity analysts said Marathon Oil Corp
        hedged about 38% and Pioneer Natural Resources Co
        54% of estimated 2020 production, using three-way
    Marathon and Pioneer did not respond to requests for
    Marathon was one of numerous companies this week that
announced drastic spending cuts.                          
    Futures and options-market volumes hit a record on Monday,
CME Group said. Some shale companies are looking to unwind
hedges, selling the financial contracts to generate cash, market
sources said, adding that others are looking to restructure
their hedge positions to secure protection at lower price
    Occidental Petroleum Corp         constructed a complicated
hedge that protected their selling price for 2020 down to $45
per barrel of Brent while leaving them fully exposed to downside
in 2021, according to company filings. That company cut its
dividend by 86% this week and said it would slash spending.
    "The whole industry is not evenly hedged," said Trisha
Curtis, co-founder of Denver-based consultancy PetroNerds. She
said hedged operators may still need to cut back on rigs and
hydraulic fracturing fleets that produce oil and gas from shale
    Parsley Energy Inc        said on Friday it has been
restructuring some of its 2020 hedge positions to provide
additional protection against lower oil prices by reducing
certain short put prices. Parsley said it has also "moved
aggressively to protect its 2021 cash flow by adding swap
positions." The company also asked its service providers to cut
their prices, a move numerous companies are taking, sources
    However, it costs much more for oil and gas producers to
hedge now than it did five years ago, and they must do it at a
lower absolute price, said Basil Karampelas, managing director
at advisory firm SierraConstellation Partners. 
    "They're in a low price, high volatility quadrant where it's
the square of death."
    Some firms were not hedged at all, including Apache Corp
        and Continental Resources Inc        , according to the
latest annual filings.
    "Apache's approach in response to oil price dislocations has
been to quickly adjust our activity and spending as appropriate,
and that is what we are doing now," Gary Clark, vice president
of investor relations at Apache, said in a statement. The
company has other non-shale operations that also act as natural
hedges, he said. 
    Continental did not respond to a request for comment.
    Shale firms are only now starting to hedge for 2021. Goldman
Sachs said just 2% of production for 2021 has been hedged, and
now companies face the likelihood that they will not be able to
lock in prices that will guarantee profits given their costs.
    Most shale companies need prices above $40 per barrel to
break even on costs at the well. Prices are far below that level
    "Our clients are now all re-evaluating the hedges they
have," Steve Sinos, vice president of Mercatus Energy Advisors.

 (Reporting by Devika Krishna Kumar in New York and Liz Hampton
in Denver; Editing by David Gregorio and Marguerita Choy)
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