These Poorly Hedged Bakken And Eagle Ford Oil E&P Companies Could Get Hurt In A Downturn

Includes: ROSE, WLL
by: David White

Barclays was the only major bank in the last Reuters monthly poll to maintain a 2013 Brent price forecast above $120/barrel. On Wednesday April 3, 2013, Barclays cut its Brent forecast to $112/barrel on average for 2013. Goldman Sachs cut its forecasts steeply in October 2012. It cited a rise in unconventional oil supplies in the US and Canada as the reason; and that was when the US Q3 GDP growth of +3.1% was the basis of the estimate. Since that time the US has seen a lot of data that indicates a significant US slowdown if not a US recession in 2013. The sharp drop in the US Q4 2012 GDP growth to +0.4% was the first of the negative data items.

The EU recession was the second. The EU GDP growth was down by -0.9% year over year in the Euro Area and -0.6% in the EU 27 in Q4 2012. These numbers were in turn down significantly from the -0.6% and the -0.4% in Q3 2012, respectively. More recently, the EU manufacturing PMI fell from 47.9 in February 2013 to 46.8 in March. Approximately 1000 businesses per day have been failing in Italy for the last year. It has only 6 million businesses. This means a lot of bankruptcies both personal and commercial. It means more pressure on all of the ongoing concerns because they will get less business from the newly unemployed. It means a huge increase in bad loans. This will lead to bank failures, etc.

The same can be said for Spain. It has 26.1% unemployment. It saw a seasonally adjusted -10.2% drop in January 2013 retail sales year over year. This data followed an -11.4% decline in December. Non-food product sales plunged -11.6% in January 2013. Spain has a truly terrible real estate problem. It has ghost towns of empty new houses that are going to seed. Its banks have already gotten one bailout; but that won't be nearly enough to solve all their problems. The ever increasing number of unemployed are simply not feeding the remaining businesses. The country is in a downward spiral that shows no signs of abating. Economic ruination seems inevitable if more constructive actions are not taken. The entire EU hit a record unemployment of 12.0% in February 2013. Even Germany's economy shrank in Q4 2012 by -0.6%.

On top of this, Japan's economy shrank by -0.7% year over year in the October-December quarter of 2012. The OECD (most western developed countries) GDP contracted by -0.2% in Q4 2012. The negative growth of these other major economies will put a damper on the US economy. These countries will buy fewer US goods. They will try to dump more of their own goods in US markets. This will make it harder for US firms to remain profitable. Let us give this factor a -0.5% effect on US 2013 GDP as a ballpark figure. It may deserve a stronger weighting, especially if the situation deteriorates appreciably.

With the above environment as a back drop, the US raised the payroll taxes in January 2013 by +2.9%. Plus it raised a number of taxes on the rich, including a 3.8% ObamaCare surtax on investment income. Mark Zandi of Moody's estimates these new taxes may trim -1.4% from US GDP growth in Q1 2013 (and probably roughly as much for the rest of 2013). Subsequently, Obama has put the sequester into effect. The CBO, a historically conservative organization, estimates that the sequester will knock -0.6% off US GDP growth in 2013; and it lead to the loss of 750,000 US jobs. Adding the above GDP growth losses together, you get a loss of about -2.5% in US GDP growth from whatever the number would have been otherwise. Even if you thought US GDP growth was going to be in the 2%-3% range, these numbers have to make you think a recession is likely. If you had lower original estimates, you should think a US recession is a certainty.

On top of these negative economic factors, which may severely impact oil demand, the EIA expects US crude oil production to grow rapidly in the next two years from 6.5 million bopd in 2012 to 7.3 million bopd in 2013 to 7.9 million bopd in 2014. This is expected to put a damper on oil prices, especially in the US and Canada. If a US recession comes, US oil prices could easily fall to a range of $60-$80 per barrel. Even without a recession they seem likely to fall with the currently slow US and world economies. The NonFarm Payrolls data released on April 5, 2013 showed only 88,000 jobs gained in March. Analysts had expected a gain of 200,000 new jobs. Further the household survey showed the workforce down by 496,000 in March compared with a decline of 130,000 in February 2013. Does that sound like someone is cooking the books? Add to this the last two Initial Claims data points missed badly. Core Factory Orders and Core Durable Goods were both negative. The ISM Index missed at 51.3 versus and expected 54.0. The ISM Service missed at 54.4 versus and expected 55.5. I could go on. The point is that the US economic data has been weakening lately (much more quickly than expected).

Any significant fall in WTI crude prices will specifically hurt those oil companies that are poorly hedged against a fall. For simplicity's sake, I am only considering the WTI price. Since the Bakken and Eagle Ford are two of the most prolific fields in the US, let's look at the hedges of two of those companies.

Rosetta Resources Inc. (NASDAQ:ROSE) expects its FY2013 production to average 47-51 Mboe/d. The mean of that is 49,000 Boe/d. The January 2013 average production was 47.4 Mboe/d. 29% of that was oil and 34% NGLs. ROSE's oil hedges for FY2013 include 7,750 bpd collared at $81.52 at the bottom and 3,000 bpd with swaps at $95.72. 29% of 49 Mbopd is 14,210 bopd. Hence if the price of oil falls dramatically, ROSE will have approximately 2,460 bopd completely unhedged. These barrels will go down as far as the price of oil goes down.

For this example, let us say the price of oil goes down to an average price of $70/barrel for 6 months. Recently the price of oil has been in the $95/barrel range. I will calculate any losses of revenue from this figure. 3,000 barrels will realize $0.72 more due to swaps or $2160/day for 182 days. This is +$393,120 for the six months in question. The 7,750 barrels collared at $81.52 will lose $13.48 per barrel. This will result in a total loss for the six months in question of roughly $19 million. The unhedged 2,460 bpd will lose $25 per barrel. This amounts to roughly $11.19 million in the six month period. The total of all of these is +0.39 - 19 - 11.19 = approximately $29.8 million in revenues. Since no less effort was used to produce this lesser revenue, I will ballpark subtract 2/3 of the total from adjusted net income. For FY2012 adjusted net income was $146.7 million. Six months of this would be $73.35 million. 2/3 * $29.8 million is $19.87 million. $19.87 million is approximately 27% of adjusted EPS over the 6 month time frame. Such a loss would put severe pressure on the stock price. Plus it might cause a cut back in CAPEX spending, which would in turn cause slower production growth. This would negatively impact the long term outlook. Plus I haven't even dealt with NGLs and natural gas production revenues, which would also likely be negatively affected. ROSE's price would surely go down. Taking some profits now might be a good idea.

Whiting Petroleum (NYSE:WLL) had Q4 2012 oil production of 86.1 Mboe/d of which 80% was oil. I will just use 2012 numbers with 2013 hedges for this example for less confusion. WLL has 3-way collars of $71.25 - $85.63 - $113.95 for 48.1% of oil production for Q2-Q4 of 2013. We have already passed Q1 2013. Plus it has another 13.6% with a collar of $48.17 - $90.71 for Q2 and Q3. I chose not to deal with Q4 as that would add unnecessary complexity. This means that 38.3% of production is completely unhedged. Let me explain the three way collar. The upper price is a call that was sold to help defer the cost of the put. It caps possible gains. The middle price is the put WLL is long. It caps the losses down to the lowest price, which is the put WLL is short.

Using the same example for WLL as above, the price of oil will fall to an average price of $70/barrel for a period of 6 months. The current average price is assumed to be $95/barrel (even though it is slightly lower than that today April 5, 2013). For this example, WLL will lose $25/barrel on the 38.3% of oil production that is not hedged. It will lose $25 per barrel on the 13.6% of the oil production which has only the minimum downside protection of approximately $48/barrel. It will lose $9.37 + $1.25 = $10.62 per barrel on the oil that is covered by the three way collars.

Q4 2012 oil production averaged 86,100 Boe/d of which 80% was oil or 68,880 bpd of oil production. For this example 51.9% is effectively unhedged. Thus WLL will lose 68,880 bpd * 0.519 * $25/barrel * 182 days = $162.7 million for this 51.9%. It will lose 68,880 bpd * 0.481 * $10.62/barrel * 182 days = $64 million for the 48.1% that is hedged with 3-way collars. The total losses of revenues will be approximately $226.7 million. Since no less effort was used to produce and sell this oil, I will ballpark the losses to EPS at 2/3 of the $226.7 million less in revenues or $151.1 million. Adjusted net income for Q4 2012 available to common shareholders was 97.9 million. Double this for a six month period, and you get $195.8 million for six months of adjusted net income. The $151.1 million lost to lower oil prices amounts to 77% of profits. This is dramatically worse than the prognosis for ROSE. ROSE will suffer; but a sustained lower oil price will dramatically change WLL's earnings.

It is very helpful to know this if you are trying to play the oil producers as the price of oil goes up and down. The pros will all have this information many investors will not. If you believe in the significant slowdown/US recession scenario, you may want to take profits in WLL if you own it.

If you thought this ballpark estimate of possible losses due to insufficient hedging activity was helpful to your investing/trading, please look for further installments in the days and weeks to come.

NOTE: Some of the fundamental financial data above is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in WLL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.