March 13, 2020 / 5:02 AM / 18 days ago

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

    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 Thursday closed at $31.50 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.
    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 percent 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
        hedged about 38% and Pioneer Natural Resources        
54% of estimated 2020 production, using three way collars. 
    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
    "Our E&P clients are now all re-evaluating the hedges they
have," Steve Sinos, vice president of Mercatus Energy Advisors,
using the acronym for exploration and production.    
    Occidental Petroleum constructed a complicated hedge that
protected their selling price for 2020 down to $45 per barrel
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.             
    Parsley Energy restructured hedges earlier this month in
expectations of falling prices, but those changes were modest,
and were done before this week's rout.             
    "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
    Some firms were not hedged at all, including Apache        
and Continental Resources        , 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," said Gary Clark, vice
president of investor relations at Apache, in a statement. 
    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, but the market has been well
above that level for most of the last couple of years.

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