North American oil/gas companies hedging production for stronger returns – IHS Markit

Investor push for greater capital discipline and stronger returns driving strategy shifts in exploration and production sector

Nodding to increased investor pressure to deliver cash flow neutrality and stronger corporate returns, North American exploration and production (E&P) companies were more hedged than usual as they entered 2018, according to new research from IHS Markit.

According to the IHS Markit Comparative Peer Group Analysis of North American E&Ps, the group of 43 companies studied had hedged 25 per cent of 2018 oil production, or 1.37 million barrels per day, at $53.40 per barrel at the end of the third quarter 2017.

The group had also hedged 36 per cent of gas production, or 12.37 billion cubic feet per day, at $3.13 per million cubic feet (Mcf).

“The North American E&P peer group is more hedged for 2018 than for comparable periods at this time in previous years, which suggests a shift in strategy,” said Paul O’Donnell, CFA, principal energy analyst at IHS Markit and author of the hedging analysis.

This is an increase from 12 percent of oil and 31 percent of gas production hedged for 2018 at the end of the second quarter 2017, as companies took advantage of the initial oil-price rally to the low-$50s per barrel range.

“Companies are seeking more predictable cash flows because of greater investor demands to improve corporate returns and keep capital spending within cash flow. The higher level of hedging is less about supporting aggressive production growth and more about increasing investor confidence that these companies are serious about becoming more financially disciplined,” O’Donnell said.

The IHS Markit report said the small and midsize U.S. E&P subgroups had hedged 49 per cent of total 2018 production at the end of the third-quarter 2017, compared with 18 per cent for the large North American E&P subgroup.

“The current oil price rally to the mid-$60s per barrel range is an opportunity for companies to build up larger hedging positions at prices that can generate positive returns,” O’Donnell said. “We expect North American E&P companies will report significant increases to hedge books during the upcoming fourth quarter 2017 earnings cycle, particularly the non-Permian focused and Large E&Ps who have previously been less-hedged.”

The Permian E&P subgroup had hedged 63 per cent of 2018 oil production at the end of third-quarter 2017, a sharp increase from 36 per cent at the end of second-quarter 2017, but are likely to record hedging losses given the average strike price of $53.14 per barrel, IHS Markit said.

“More wells are economic at $50 per barrel and with oil prices now reaching into the mid-$60 per barrel range it makes sense that companies are using a greater amount of hedging than in prior years when oil prices were lower,” O’Donnell said.

The Permian E&P subgroup had hedged 63 per cent of 2018 oil production at the end of third-quarter 2017, a sharp increase from 36 per cent at the end of second-quarter 2017, but are likely to record hedging losses given the average strike price of $53.14 per barrel, IHS Markit said.

“Companies are opting to lock-in a larger portion of production and cash flows, which helps with capital budgeting for the upcoming period. Again, the focus now for E&Ps is on capital discipline and keeping capital expenditures within cash flows to satisfy the growing investor focus on returns, rather than chasing volume growth,” concluded O’Donnell.

The group’s average oil strike-price is below WTI oil prices, which averaged more than $55 per barrel in the fourth quarter 2017, and are currently around $64 per barrel.

The Appalachian E&P subgroup has hedged 49 per cent of 2018 gas production at $3.33 per Mcf at the end of the third quarter 2017.

This is a healthy premium to current futures prices, which are below $3 per Mcf. This compares with 44 per cent of 2018 gas production, which was hedged at $3.36 per Mcf at the end of the second quarter 2017.

At the end of the third quarter 2017, the E&P peer group had also hedged 34 per cent of fourth-quarter 2017 oil production at $52.97 per barrel, and 49 per cent of fourth-quarter 2017 natural gas production at $3.21 per Mcf.

Given that fourth-quarter 2017 WTI prices averaged more than $55 per barrel, IHS Markit analysts expect companies will report realized hedging losses for the quarter.