Bakken Update: Whiting's Hedges Provide Poor Economics At Today's Oil Prices

| About: Whiting Petroleum (WLL)

Summary

Although WLL states 45% of its 2016 production is hedged, it provides minimal pricing protection below $43.75/bbl.

Whiting's three-way collars are providing just a $10/bbl hedging gain at today's oil price.

Using hedged barrels, average payback times have extended out into several years.

Three-way collars provide much less downside protection as the introduction of a sub-floor decreases hedge gains below that specific price.

There are a large number of ways to hedge production, so investors should take great care in how it could affect future revenues.

The oil price decline has done little to decrease US production, but some believe this may change. Although shale production has decreased, this has been masked by the introduction of new oil from the offshore Gulf Coast. It has increased US production by approximately 200K bbls/d. The decrease in shale production has been much less than originally expected. There are several reasons, but mega-fracs and high-grading are the two best reasons. There are still many shale bears, even with the significant improvements to production. This in concert with lower oil service costs and hedges has created a different oil environment in the US. The West Texas Intermediate and the US Oil Fund (NYSEARCA:USO) have dropped significantly. Realized prices for WTI remain around $30/bbl, and continue to trade in a range of $27 to $34. Additional production coming online from Iran clouds the pricing picture, as does a flimsy production ceiling negotiated between the Saudis and Russians. Although this received significant media attention, the belief is this does little to decrease the current oil glut.

Mega-fracs are the introduction of high-intensity completions using large volumes of proppant and fluids. Increased source rock stimulation is the key (although there are many more very complex variables to consider), as this opens up more surface area to the well bore. This increases recoveries per well. Below is a recent EOG Resources' (NYSE:EOG) location. It has made big changes to its well design and this has significantly improved its production and decline curve.

Click to enlarge

(Source: Welldatabase.com)

The welldatabase.com map provides the pad's location. It is between New Town and Keene on the west side of the Missouri River in northeast McKenzie County. It is shown as a red star in the center of the map. A closer look shows two wells.

Click to enlarge

(Source: Welldatabase.com)

The well on the eastern side of this pad is Riverview 01-32H. It started producing in November of 2010. It used approximately 30K bbls of fluids and a million pounds of proppant. It is a 4,200-foot lateral with 15 stages. It has produced 209K Bo.

Date

Oil

Gas

Water

11/1/2010

18,610

23,877

11,027

12/1/2010

13,834

26,311

2,346

1/1/2011

10,520

13,423

2,256

2/1/2011

8,319

11,247

1,414

3/1/2011

6,642

6,764

1,151

4/1/2011

7,064

9,257

1,278

5/1/2011

6,425

8,967

1,091

6/1/2011

5,387

7,612

829

7/1/2011

3,653

4,693

542

8/1/2011

5,166

5,753

909

9/1/2011

4,794

7,924

764

10/1/2011

4,661

6,306

662

11/1/2011

4,161

5,541

598

12/1/2011

4,122

5,126

546

1/1/2012

3,897

5,015

525

2/1/2012

3,401

4,495

438

3/1/2012

3,532

5,025

476

4/1/2012

3,254

4,535

430

5/1/2012

3,291

4,648

789

6/1/2012

3,157

4,347

480

7/1/2012

1,489

2,112

217

8/1/2012

770

1,088

40

9/1/2012

3,985

5,533

460

10/1/2012

3,840

5,527

551

11/1/2012

3,366

5,171

610

12/1/2012

2,770

4,277

377

1/1/2013

3,349

4,287

517

2/1/2013

2,747

4,275

546

3/1/2013

2,655

4,378

558

4/1/2013

2,557

2,821

369

5/1/2013

2,629

1,392

462

6/1/2013

2,428

2,590

358

7/1/2013

2,455

1,458

474

8/1/2013

2,387

1,589

373

9/1/2013

2,237

1,835

447

10/1/2013

2,188

2,690

346

11/1/2013

2,240

1,896

507

12/1/2013

2,376

4,403

447

1/1/2014

2,255

4,242

399

2/1/2014

2,172

4,096

386

3/1/2014

2,130

4,127

526

4/1/2014

1,851

2,821

469

5/1/2014

1,783

2,981

374

6/1/2014

1,863

3,416

427

7/1/2014

1,921

4,244

429

8/1/2014

1,944

4,309

424

9/1/2014

1,752

4,925

286

10/1/2014

2,110

5,783

692

11/1/2014

1,851

3,984

487

12/1/2014

1,649

3,524

440

1/1/2015

1,982

4,496

384

2/1/2015

114

235

117

3/1/2015

0

0

0

4/1/2015

0

0

0

5/1/2015

0

0

0

6/1/2015

0

0

0

7/1/2015

2,869

4,098

687

8/1/2015

3,029

5,421

607

9/1/2015

2,523

5,126

629

10/1/2015

2,360

4,992

786

11/1/2015

2,119

4,985

467

Click to enlarge

(Source: Welldatabase)

Riverview 102-32H started producing in June of 2015. It is a 4,200-foot, 23-stage lateral. It used 150K bbls of fluids and 13 million lbs of proppant. Production improved significantly, as this is one of EOG's best Bakken wells ever.

Date

Oil

Gas

Water

6/1/2015

36,401

346

11454

7/1/2015

86,922

178,373

22132

8/1/2015

39,587

70,189

11087

9/1/2015

45,634

81,474

11980

10/1/2015

39,211

82,984

10746

11/1/2015

23,234

67,426

7765

Click to enlarge

(Source: Welldatabase.com)

This well has produced 271K Bo in its first six producing months. Month 2 provided almost 87K Bo alone. This is one of the best single months in the history of ND. Keep in mind, these results are not typical, but the point was to show the improvement in well design in five years. It is difficult to find well pads with just two wells, and completions with this much time between. Mega-fracs will continue to improve well economics. Operators have increased the use of high-intensity frac jobs. Lower proppant and fluid costs have provided incentive to increase the usage. No wells are economic at today's prices, unless the operator is hedged.

When oil prices tanked in 2008, many operators almost went out of business. In response, they began to hedge production. Without getting in-depth, hedging is a way for oil and gas companies to lock in prices going forward. There are many types of hedges including swaps and collars. A collar is one of the most common and it limits both the upside and downside to the oil and natural gas prices. The collar's floor (long put) is the absolute minimum price the operator will receive for the resource. The ceiling (short call) is the most it would receive. An operator will hedge a percentage or all of their estimated production for a year's time.

For example, an operator may have a ceiling of $70/bbl and a floor of $50/bbl. If oil trades for $84/bbl, they would only receive $70/bbl. If oil trades for $30/bbl, they will receive $50/bbl. This is very useful as an E&P can estimate their maximum and minimum revenue range for the barrels hedged. Many ask why an operator would want to limit the upside, and the key is cost. By setting the ceiling, they reduce the cost of the hedge. The premium paid for the put is offset by the premium received by selling the call, resulting in a costless collar. In general, an operator pays someone to take the burden of the downside to oil prices. It then is paid by one that wants the upside to oil prices. This is a simplistic description, but gives a basic description.

Oil and gas companies will sometimes just hedge with put options to protect the downside, but due to the cost/bbl, we usually see collars. Swaps are also very common. It is used to lock in a specific price. These are called swaps because it is an agreement to swap cash flows. One would buy the swap to guarantee a specific price while the one selling will take what the market bares. Depending on the average price of WTI for a specific month, an operator will experience a hedging loss or gain as the difference. Operators need to hedge, and mostly for the downside. Many have gone out of business during oil gluts, so it behooves one to be conservative. The issue with oil companies hedging production is many are not very good at it. Over the years, there have been a large number of problems associated with operators making the wrong call on prices, but the main concern is receiving a dollar amount that is profitable. In some cases, a great call is made. In these cases, some believe operators should sell their hedge book and stop producing. Although this seems like a good idea, a company isn't in the business of hedging crude. They are in the business of producing it. Little is served by firing the majority of one's staff and essentially shutting down until prices improve. Many times, operators will decrease cap ex and try to reduce costs. This is done until prices improve, if they can hold on.

There is one type of hedge that may be problematic for operators in 2016. The three-way collar is a collar where there is selling of a further out-of-the-money put option. This is also known as a subfloor. Operators engage in three-way collars because it has a lower cost. In some cases, these generate revenue. The issue is added risk. By selling a further out-of-the-money put, it is possible an operator will see limited downside protection. By adding the short put or subfloor, it decreases the benefit of the long put or floor. The tighter the differential from the floor and subfloor, the less beneficial the hedge with low oil prices.

There are a large number of operators using this hedging instrument, and I will go over some in this article.

Click to enlarge

(Source: Whiting)

Whiting (NYSE:WLL) is a name we believe could have serious headwinds going forward. Even if we see $60/bbl WTI by year end, it will probably not be the Q4 average. In Q3'16, we think oil will trade between $40 and $50/bbl. In Q4'16, that range will mainly be $45 to $55/bbl. $50 will become a very difficult level to break through, as operators will try to get hedged around these levels. Volatility is expected. Whiting's problems are many. It has higher costs, and Bakken differentials. State taxes will also weigh. We covered these problems for ND operators in several articles this year. Bakken Update: Reiterating A Short On Emerald Oil (NYSEMKT:EOX) Which Is Down 99% Since the Call and Bakken Update: Halcon (NYSE:HK) is Down 97% Since Our Call To Short, But Further Downside May Be Ahead both cover Bakken operators with marginal acreage and high debt. Emerald doesn't have any core acreage and Halcon only has a small footprint. Whiting has some very good Bakken core acreage, but also a very large leasehold outside the core. This acreage may not be viable at $60/bbl, so hedging is of utmost importance. Whiting is pressed to get its remaining acreage held by production, which it may have to do at a loss or let some leasehold go.

In 2016, WLL has 37.9% of its production hedged using three-way collars. An additional 6.8% is covered through collars. Its collars have a ceiling of $63.48/bbl and floor of $51/bbl. Its three-way collars have a ceiling of $74.40, floor of $53.75 and a subfloor of $43.75. It went with three-way collars because the subfloor allowed an increase in the ceiling of almost $11/bbl. Whiting realized that if oil is below $43.75, it will receive $10/bbl more than the current price realizations. Below is a graph to provide a little clearer picture of how this works:

WTI Price

Subfloor $43.75

Floor $53.75

Ceiling $74.40

Gain/Loss

Price Realization

$75

($.60)

($.60)

$74.40

$70

$70.00

$65

$65.00

$60

$60.00

$55

$55.00

$50

$3.75

$3.75

$53.75

$45

$8.75

$8.75

$53.75

$40

($3.75)

$13.75

$10.00

$50

$35

($8.75)

$18.75

$10.00

$45

$30

($13.75)

$23.75

$10.00

$40

$25

($18.75)

$28.75

$10.00

$35

$20

($23.75)

$33.75

$10.00

$30

Click to enlarge

Whiting will look like a genius if the price of oil heads to $70/bbl, but may have made the wrong choice in stretching to increase the ceiling on its hedge. The company may have been aggressive in hopes of being able to develop some non-core locations. Since its non-core acreage has more difficult economics, it will have difficulty in working those areas below break-even prices.

Hopefully, the above table is clear in how hedge gains and losses will work for Whiting. Anything above $74.40 will be a hedge loss due to the short call. As an example, if oil was at $100/bbl, Whiting would see a hedging loss of $25.60/bbl. The long put allows WLL to book hedging gains below $53.75. So, if we see an average monthly oil price of $33.75/bbl, it would book a hedging gain of $20/bbl. As I said earlier, the short put or subfloor limits the gains seen from the long put. Because of this, it will only see gains of approximately $10/bbl below $43.75.

Whiting's three-way collars cover 1.4 million barrels per quarter. This is substantial. If the company had chosen to not to use three-ways and went the $63.48 ceiling and $51.00 floor, it would probably realize much better prices. If we use a hypothetical $30/bbl average WTI (plug in your own price if you think this is improper) price for 1H'16 for the 2.8 million bbls hedged, Whiting would gain revenues of $30.8 million. This is just a guess, but unless things change, this proved to be a poor decision. Whiting, like many other operators, was late to get hedged. Because of this, it is poorly positioned in 2016. This may be why Moody's dropped Whiting's corporate family rating five notches deeper into junk territory.

WLL is currently 45% hedged for 2016. It is very important to understand how its hedges work, and how they affect well economics. Not all wells are created equal, as the Riverview well shows earlier in the article. I have taken a group of wells Whiting completed in June of 2014. I chose this month as it provides a number of wells (although the company is currently focusing on its best acreage) to average but more importantly, 18 months of production. This is the magic number, as most operators would like to reach payback in this time. This may not be the case today, as low oil prices have changed the way operators look at payback times. I would have gone further out, but want to use wells with a more up-to-date completion style. This keeps production results up to date.

Click to enlarge

(Source: Welldatabase.com)

These wells are spread out throughout its acreage in ND (I did not include Montana completions). The majority were in McKenzie County. Although McKenzie has some of the best wells to date, there is a very large difference in production from one end of the county to the next.

Click to enlarge

(Source: Welldatabase.com)

12 wells are completed in McKenzie, four in Mountrail, two in Stark and one in Williams. We better understand the data when production is broken down by field.

Name

Well Count

CUM Gas [MCF]

CUM Oil [BBL]

CUM Water

Poe

5

939,910

582,046

597,937

Pleasant Hill

4

748,851

399,009

398,934

Sanish

4

784,566

490,751

106,274

Twin Valley

2

1,504,789

596,410

116,856

Zenith

2

173,578

180,163

156,158

East Fork

1

99,920

71,086

128,505

Juniper

1

222,978

124,896

166,007

Click to enlarge

(Source: Welldatabase.com)

Although the majority of wells were completed in the Poe field, Twin Valley is the best producer. Twin Valley field is in a sweet spot of the Bakken, and has had some monster wells. It is a very high pressured area as shown by the volumes of natural gas produced. Sanish field is a surprise, as it is thought of as one of the better fields in North Dakota. Twin Valley, Sanish and Poe fields are considered core. But Twin Valley and Sanish have produced a number of top Bakken wells. Twin Valley has had excellent Three Forks wells. The Sanish Three Forks is not as good. Pleasant Hill, Zenith, East Fork and Juniper are considered marginal. This provides a balance as 11 wells are in good areas and eight of these completions are not in good acreage.

Date

Oil

Gas

H2O

Wells

6/30/2014

321,920.00

551,555.00

365,368.00

19

7/31/2014

276,356.00

458,447.00

188,417.00

19

8/31/2014

176,923.00

278,990.00

116,108.00

19

9/30/2014

190,036.00

279,628.00

113,081.00

19

10/31/2014

185,912.00

279,972.00

98,949.00

19

11/30/2014

149,954.00

239,334.00

97,523.00

19

12/31/2014

128,761.00

223,732.00

76,511.00

19

1/31/2015

142,316.00

258,840.00

90,058.00

19

2/28/2015

115,623.00

218,433.00

64,121.00

19

3/31/2015

114,999.00

233,134.00

65,438.00

19

4/30/2015

99,201.00

215,270.00

59,279.00

19

5/31/2015

90,730.00

198,268.00

53,283.00

19

6/30/2015

86,281.00

191,978.00

51,441.00

19

7/31/2015

83,130.00

192,596.00

51,314.00

19

8/31/2015

74,386.00

171,157.00

46,693.00

19

9/30/2015

71,712.00

162,165.00

44,562.00

19

10/31/2015

71,156.00

167,034.00

46,214.00

19

11/30/2015

64,965.00

154,059.00

42,311.00

19

Click to enlarge

(Source: Welldatabase.com)

The above table provides the average production decline over 18 months. The 12-month decline was just under 72%.

Click to enlarge

Red: Natural Gas

Green: Oil

Blue: Water

Grey: Boe

(Source: Welldatabase.com)

Total 18-month production is 2.44 MMBo and 4.47 Bcf. The average production/well is 128,421 Bo and 235,263 Mcf. Using Whiting's current hedges, average 18-month oil revenues at $30 WTI is $4.11 million. This includes a hedge gain of $10 and a Bakken differential of $8/bbl. Using a $4/Mcf natural gas price (I averaged in the additional gain of NGLs), average natural gas revenues are $941,052. Total average revenues to date are $5.05 million. After taxes are removed, revenues are reduced to $4.6 million. After reducing this by LOE, G&A, and interest, it is reduced to $1.4 million. Whiting's current well cost is $6.5 million, leaving $5.1 million to reach payback. There are several very important variables to consider. The three-way collar only allows for a $10/bbl hedging gain due to the subfloor. Differentials, depending on the operator, will essentially cancel out this gain. Interest payments due to debt add over $5/Boe. When this is added to a relatively large marginal acreage position, it makes things very difficult. Keep in mind, only 45% of production is hedged. Operating costs are over $22/Boe, so this leaves very little room to reach reasonable payback times. We think Whiting continues to have issues going forward. This is supported by its recent decision to cancel 20 planned wells and a gathering pipeline project. Moody's recently downgraded Whiting's debt five notches. This is another levered Bakken name with a large marginal acreage position that could continue to have difficulties. We expect dilutive capital raises and possible asset sales going forward.

Additional exposure to three-way collars by other US unconventional operators is provided below. Keep in mind, each operator will be affected differently. Payback times can differ greatly by operator and play.

Click to enlarge

(Source: Callon)

Callon (NYSE:CPE) also participated in three-way collars. It has been an interesting play, getting a very small acreage position in the Midland Basin core. Its central acreage is among the best in the country with very low costs. Although this stock is speculative, it becomes interesting due to its core acreage. There are probably some better Permian players to focus on.

Click to enlarge

(Source: Callon)

CPE is very well hedged with respect to volumes. It is in a much better position than Whiting. Its three-ways constitute half of its hedged barrels. Its swaps provide a hedge gain of almost $20/bbl this quarter (depending on where oil prices go from here). Its three-ways are lower as its $55 long put or floor is diminished by its subfloor of $40.33. When Callon hedged, it may have thought oil would trade above this level. Currently, its hedged gain is approximately $14.67 above current WTI prices. This means half of its oil production, after hedge gains, will be at $58.23/bbl and the other half at around $45/bbl using today's prices.

Click to enlarge

(Source: Pioneer)

Some may be a little worried about Pioneer's (NYSE:PXD) hedges, but Q1'16 looks ok given its low operating costs. These costs are better in the Midland and Delaware (Permian) basins than any major US unconventional play.

WTI Price

Subfloor $43.17

Floor $63.04

Ceiling $73.29

Gain/Loss

Price Realization

$100

($26.71)

($26.71)

$73.29

$95

($21.71)

($21.71)

$73.29

$90

($16.71)

($16.71)

$73.29

$85

($11.71)

($11.71)

$73.29

$80

($6.71)

($6.71)

$73.29

$75

($1.71)

($1.71)

$73.29

$70

$70.00

$65

$65.00

$60

$3.04

$3.04

$63.04

$55

$8.04

$8.04

$63.04

$50

$13.04

$13.04

$63.04

$45

$18.04

$18.04

$63.04

$40

($3.17)

$23.04

$19.87

$59.87

$35

($8.17)

$28.04

$19.87

$54.87

$30

($13.17)

$33.04

$19.87

$49.87

$25

($18.17)

$38.04

$19.87

$44.87

$20

($23.17)

$43.04

$19.87

$39.87

Click to enlarge

Pioneer's current 2016 oil hedge position is 85% of total production. In Q1'16, it has 35,000 bopd covered with swaps at $59.88. Another 63,000 bopd are hedged with three-way collars. These have a ceiling of $73.29, floor of $63.04, and a subfloor of $43.17. If we use $30 WTI, we see why swaps are a much more appropriate vehicle for hedging in a down-market. Pioneer is receiving $59.88/bbl via swaps versus $49.87 with three-way collars. More importantly, PXD's three-ways are decreasing revenues significantly. In Q1'16, the subfloors ($30/bbl WTI) would cost Pioneer approximately $75.5 million. This may be why PXD reversed its plan and decided to cut spending. Although its three-ways are losing revenues, the placement of its floor and subfloor are important. Below $40/bbl, it receives a hedging gain of almost $20/bbl. This is exceptional considering the derivative.

Click to enlarge

(Source: Pioneer)

Enerplus (NYSE:ERF) has 53% of oil production hedged in Q1'16. This number shrinks to 34% in Q2 and 25% in the second half of the year. In Q1, almost half of hedged volumes are three-way collars.

WTI Price

Subfloor $50.13

Floor $64.38

Ceiling $79.38

Gain/Loss

Price Realization

$85

($5.62)

($5.62)

$79.38

$80

($.62)

($.62)

$79.38

$75

$75.00

$70

$70.00

$65

$65.00

$60

$4.38

$4.38

$64.38

$55

$9.38

$9.38

$64.38

$50

(.13)

$14.38

$14.25

$64.25

$45

(5.13)

$19.38

$14.25

$59.25

$40

($10.13)

$24.38

$14.25

$54.25

$35

($15.13)

$29.38

$14.25

$49.25

$30

($20.13)

$34.38

$14.25

$44.25

$25

($25.13)

$39.38

$14.25

$39.25

$20

($30.13)

$44.38

$14.25

$34.25

Click to enlarge

Some operators are less affected by hedges. Enerplus has significant exposure to subfloors. Roughly half of its hedged barrels are providing a gain of $14.25/bbl. Its situation is not as dire as Whiting from a derivative standpoint, but still difficult.

Click to enlarge

(Source: Enerplus)

Baytex (NYSE:BTE) also has exposure to subfloors. It has exposure to both light/sweet and heavy/sour crudes. 43% of its production is heavy, which has a much lower selling price than light/sweet crude. The glut has affected all blends, but the Canadian oil market especially. The majority of production increases from the Saudis have been heavy, which has also created difficulties for Venezuela.

Click to enlarge

(Source: Baytex)

Baytex sold its Bakken acreage, which was a good move. None of its acreage was in the North Dakota core, with the majority in Divide County. The average break-even cost in Divide is $81/bbl according to the NDIC.

Click to enlarge

(Source: NDIC)

This number varies significantly by field, but it still shows the high cost of doing business in the marginal Bakken/Three Forks. This and other divestitures have helped lower the debt. The addition of Eagle Ford acreage was positive. Lower taxes, operating costs and tighter differentials have been a benefit. Baytex has a tough road ahead. It has 40% of production hedged, and 67% of it are three-way collars. Although the ceiling is low, it may be set right for this year. There is a very good chance WTI spends little or no time above $60/bbl in 2016. It also receives $10/bbl more for WTI when below $40/bbl. This means $30 WTI provides a hedging gain of $10/bbl.

Abraxas (NASDAQ:AXAS) has 1,948 Bo/d hedged in 2016. This accounts for approximately half of its estimated 2016 crude production. Half of the barrels are $84.10 swaps. The other half are three-way collars, which account for approximately a quarter of the estimated production.

Click to enlarge

(Source: Abraxas)

Abraxas' ceiling is $71.00/bbl. The floor is $60 and subfloor $45. It doesn't look like we will see $71/bbl WTI this year, but the $60 floor should be adequate for its McKenzie County Bakken locations. When oil is below $45/bbl, the company will receive a $15/bbl hedge gain. The subfloor does decrease revenues, but Abraxas is in a decent position considering its swaps. Some of its Bakken acreage is core. Break-even costs are low, and it provides a better outlook when compared to some of the other names in this article. Its southern Delaware Basin acreage is also interesting.

Click to enlarge

(Source: Cimarex)

Cimarex (NYSE:XEC) is one of our favorite names. Although weighted to natural gas, it has excellent acreage in the Delaware Basin. Delaware has seen less development than Midland, but initial results are promising. Several intervals across a large leasehold have provided superior economics to the Bakken and Eagle Ford. In Q1'16, it is using three-way collars as its only means of crude hedging. These derivatives have a ceiling of $60, floor of $50 and $40 subfloor. At first look, it would seem that Cimarex is receiving approximately $10 more than WTI. This isn't the case, as it is only hedged for 273K bbls in Q1. This compares to its current production of approximately 46K bbls/d. Basically, it is hedged for approximately six days of production in Q1. Cimarex has focused more on natural gas hedging. This is why it increased hedges significantly in Q2'16. Cimarex is better placed than many other US operators due to low operating costs.

Click to enlarge

(Source: RSP Permian)

RSP Permian (NYSE:RSPP) produces approximately 15,800 Bo/d. All of its current crude hedges are three-way collars, but those cover just 1,516 Bo/d. 9.5% of production is receiving a $10/bbl gain below $45/bbl.

Click to enlarge

(Source: Encana)

Encana (NYSE:ECA) has done a good job of hedging. 2016F guidance is for oil and condensate production of 75 to 85 Mbbls/d. It has hedged a little under that with the majority in swaps at $58.85/bbl. Less than one-third are three-way collars.

WTI Price

Subfloor $47.24

Floor $55.00

Ceiling $63.03

Gain/Loss

Price Realization

$70

($6.97)

($6.97)

$63.03

$65

($1.97)

($1.97)

$63.03

$60

$60.00

$55

$55.00

$50

$5.00

$5.00

$55.00

$45

($2.24)

$10.00

$7.76

$52.76

$40

($7.24)

$15.00

$7.76

$47.76

$35

($12.24)

$20.00

$7.76

$42.76

$30

($17.24)

$25.00

$7.76

$37.76

$25

($22.24)

$30.00

$7.76

$32.76

$20

($27.24)

$35.00

$7.76

$27.76

Click to enlarge

Looking at Encana's three-way collar structure, it is the least favorable of the group highlighted in this article. Not only is the ceiling quite low (that may not matter), but also there is only $7.76/bbl difference between the floor and subfloor. This means it has a $7.76 plus WTI differential below $50. It had 18,300 Bo/d at the end of Q3.

Click to enlarge

(Source: Encana)

Its 2016 swaps number 38,000 Bo/d, but are valued at over 10x that of its three-way collars. The above screen shot provides the expense involved in swaps when compared to collars. This is the reason why collars are used. When operators run low on cash, they are motivated to hedge at a lower cost. Swaps are a guaranteed number. It allows operators to better plan cash flows going forward. Collars provide more risk and variability. If oil prices surprise to the upside, this is generally a positive as the ceiling can be placed higher. If prices head lower, swaps are generally a better option.

In summary, Whiting's current hedges provide a cloudy outlook. At first glance, it looks well hedged, when in reality, well economics are strained. Current hedge gains are a little better than differentials, so WLL is realizing only slightly better than WTI. It is highly leveraged, and interest payments are also pressuring margins. Although a top Bakken producer, its marginal acreage footprint is large. Since oil prices will be low for some time, development of these areas could be difficult. We believe all Bakken names will underperform other major US shale plays. For this reason, Whiting may be headed lower for the next six months. Given the precipitous fall in stock price, it may be best to stay away.

In general, operator hedge books are very important. The above descriptions are simplistic so take it with a grain of salt. It is meant as a basic idea of how three-way collars work. There are many ways to use derivatives to lock in specific oil and natural gas prices. The three-way collars differ from one company to the next, as do reasons for its use. In a low oil price environment, it is important to look at the difference between the floor and subfloor. This difference equates to the size of the gain when prices are below the subfloor.

Historically, operators have done an inadequate job of hedging. There are many reasons for this, but much is due to current oil prices. When oil prices are high, they may choose not to hedge significant barrels in the hopes prices will maintain. Since oil prices generally pull back quickly, some may be left without adequate protection. Since operators are reacting to market changes instead of anticipating, results are not as good. This is today's situation, and some operators have been forced to hedge at low prices. It is also important to focus on company acreage. Different leaseholds have varying operating costs. This can be affected by geology, infrastructure, and resource mix. We must keep in mind that some operators can survive current oil prices while others will not. There are more variables to consider, but some operators have chosen three-way collars out of necessity while others have low enough costs that it doesn't matter. Hedges are not the only way to judge an oil company, but understanding the differences is very important.

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