“You’re going to see less hedging activity because management is more optimistic,” said Paul Cheng, an analyst at Scotiabank. “The best hedge is a strong balance sheet.”
Since the shale boom began in the early 2010s, U.S. producers have routinely pounced on rallies to lock in prices. That risk management helps them ensure the cash flow required to make capital expenditure commitments. Producers, many of whom were already doing some hedging, got even deeper into the practice after April 2020 when the price of crude turned briefly negative. Since then, West Texas Intermediate crude, the U.S. benchmark, has made a stunning recovery, soaring above $130 a barrel in intraday trading this month to the highest levels since 2008.
“Management teams have greater FOMO,” or fear of missing out, “being hedged in a runaway market,” said Michael Tran, an analyst at RBC Capital Markets. With prices rising and companies’ books stronger than they’ve been in years, many drillers are opting out of their usual hedging activity. “Fortified corporate balance sheets, reduced debt burdens and the most constructive market outlook in years has sapped producer hedging programs,” he said.
Pioneer Natural Resources Co., the biggest oil producer in the Permian Basin, has closed out almost all of its hedges for this year in order to capture any run-up in prices. Shale producer Antero Resources Corp. is the “least hedged” in the company’s history, its finance chief said last month. Devon Energy Corp. is only about 20% hedged, compared to around 50% normally, and it plans to stay that way as prices show few signs of slowdown.
“It has been overwhelmingly the request of our investors,” Devon Chief Executive Officer Rick Muncrief said in a recent interview at Bloomberg News headquarters in New York when asked about the decision to hedge less. “We have a stronger balance sheet than we’ve ever had, and we have more and more investors that want exposure to the commodity price.”
Oil producers’ recent moves to pare back hedging were in motion weeks or even months before Russian President Vladimir Putin’s invasion of Ukraine or the U.S.’s subsequent ban on Russian oil imports. Emboldened by signs of rising gasoline and jet fuel consumption, a shortage of new crude production coming online and a widening backwardation—a bullish market signal where current prices are trading higher than future ones—explorers exiting their hedges made a bet that oil would continue to climb higher after a more than 50% advance last year. And that wager has so far paid off.
But beyond just higher selling prices and happy investors, energy producers’ decision to stop hedging future output could have major implications up and down the forward price curve. Producers act as natural sellers in futures contracts some 12 to 18 months ahead; without them, trading in later months has less liquidity and fewer checks, leading to more volatility and potentially bigger rallies.
Weak forward prices relative to oil for immediate delivery has been a key reason for underinvestment in the market. So higher oil prices in the future could be exactly the signal producers need to invest in drilling projects, which had slowed as the world attempts to transition away from fossil fuels.
“A higher forward curve is the economic SOS signal to the market incentivizing incremental future production,” RBC’s Tran said.
At the same time, elevated forward prices are a tough pill to swallow for major energy consumers, like airlines, who’ve found their own hedges to lock in fuel prices have gotten increasingly expensive. Some U.S. airlines have even begun paring flight plans due to soaring fuel prices.
Hedging has been a double-edged sword for producers in the past. Although the practice is broadly meant to protect against a sudden collapse in prices, the way many producer hedges are set up includes selling a call option above the market, a so-called three-way collar structure. This is intended to reduce costs laid out by the oil company, but a rapid rise in prices can lead to significant losses.
In total, producers racked up billions in losses from their oil hedges in 2021 as prices rallied. Some pared back hedging in 2022 to avoid it happening again; other companies who were regular hedgers have been bought out by rivals that rarely or never hedge, removing those deal flows from the market.
One of the biggest signs oil producers are throwing in the towel on hedging can be seen in the options market. The number of bullish call options traded outnumbered the number of put options—used by oil producers to lock in future selling prices—for 13 months in a row as of February. That is the longest such streak on record, based on Bloomberg data going back to 1996.
To be sure, not all producer hedging is likely to disappear as smaller private companies that have high levels of debt will almost certainly be required to hedge by the banks that lend to them. And as volatility in the immediate months rise, producers are also expected to lock in some protection short term or use more nuanced hedging to mitigate risk.
“With less focus on continually rolling large debt loads, instead of doing two or three year rolling hedges, they’re looking at 90 days and six months to protect cash flow promises,” said Steve Sinos at Blue Lacy Advisors, which provides hedging consultation for producers and consumers of oil. “They’re still putting capital to work in a commodity environment but the risk is concentrated in the immediate term.”
Chesapeake Energy Corp. CEO Nick Dell’Osso, for one, still sees the value in hedging, especially in the shorter term. Although his company’s oil hedging activity is inching lower—it’s 58% hedged on oil this year, which could drop in 2023 to as low as the 40% to 50% range—he’s sticking with the practice.
“We believe in hedging despite the fact that we have a great balance sheet. We believe in hedging despite the fact that prices have generally been going up,” Dell’Osso said on the sidelines of CERAWeek by S&P Global in Houston. “We’re decent as an industry in understanding the long-term supply demand fundamentals. We’re all pretty bad at understanding what’s going to happen next month with the price. That’s just not our game.”