Why Isn't ConocoPhillips Hedging?

| About: ConocoPhillips (COP)


A look at ConocoPhillips' confusing stance on hedging its upstream production.

Now that ConocoPhillips is no longer an integrated oil major with downstream operations, it needs a hedging program to shield its cash flow streams.

It appears the argument that ConocoPhillips' production base is simply too massive to hedge is overblown.

During ConocoPhillips' (NYSE:COP) annual shareholders meeting on May 10, 2016, someone brought up a very good question. William Condy asked:

My question is how come ConocoPhillips is not using a hedging program via derivatives?

Management's reply was (emphasis added):

We've looked at that in the past and I would tell you that the market is probably not big enough for a company our size and I would tell you that we're pretty naturally hedged today so we have production that's traded at West Texas Intermediate, WCS, West Canadian Select. We have international, so we're actually pretty naturally hedged as a company across all the markers.

We have looked at it to try to protect the floor and the base if we go through another downturn, but that's maybe something that you might see us think about as we go forward, but for the size company we are and ability to have a material impact on our cash flows and our budgets, it's really difficult for us to lock in a price on a significant portion of our crude such that it have a material impact on our capital and our financial plans going forward. It's something that we're actively looking at because we know that the industry has done that on the smaller company side and is there any way we could take advantage of that technique.

Before getting deeper into this, keep in mind that I personally see plenty of positives in ConocoPhillips and I am in no way a bear on the stock over the medium to long term.

Getting back to the reply up above, that statement contradicts what management had said earlier during the meeting. ConocoPhillips correctly noted that the company couldn't control energy prices, which is more or less true (short of willingly cutting its own output where possible or simply reacting to market forces like it has been and cutting down capex). Its CEO Ryan Lance went on to explain that the reason why ConocoPhillips reported a massive drop in its revenue and a multi-billion dollar loss last year was due to the company's inability to combat market forces.

While keeping that in mind, management then notes that ConocoPhillips' large operational presence around the globe acts like a natural hedge. That isn't really true, which is why its revenue and (more importantly) operating cash flow streams fell through the floor. Selling upstream production at West Texas Intermediate (America's crude pricing benchmark), Western Canadian Select (pricing benchmark for Alberta's heavy crude), and Brent (which is the primary international benchmark for crude) prices isn't hedging, it's realizing the market price for your production.

During 2014, ConocoPhillips generated $16.6 billion in operating cash flow from its continuing operations. That fell down to $7.6 billion last year, forcing the company to sell off assets, cut capex, shed its workforce, and even prompted ConocoPhillips to exit the deepwater exploration game by 2017. ConocoPhillips' balance sheet weakened materially as it took on debt to cover its outspend, with its total long-term debt load increasing from $22.565 billion at the end of 2014 to $29.455 billion at the end of Q1 2016.

Furthermore, hyping up the part that selling in international markets is somehow a major boon while also noting how important it was repealing the U.S. oil export ban (which was mentioned during a different part of the meeting), reducing the spread between WTI and Brent, further highlights ConocoPhillips' confusing stance towards hedging in a post-downstream spinoff world. As of this writing, Brent trades at a ~$1.40/barrel premium to WTI, with WCS trading more than $10/barrel below both.

We (ConocoPhillips) took a very leading role in repealing the export ban, which we felt was a policy - given our large position in North America -- we felt it was a policy that put our company at risk. So we took a pretty active role in trying to educate and advocate on behalf of repealing a law that was in place in our country since the mid-70s.

Is there a big enough hedging market for Conoco?

A production base of 1,500,000 barrels of oil equivalent a day is a huge amount of output for a predominately upstream player, but that doesn't mean there isn't a big enough hedging market out there.

For reference, Pioneer Natural Resources (NYSE:PXD) has hedged 85% of its 2016E oil output and 70% of its 2016E natural gas production at very favorable prices. Pioneer Natural Resources expects to produce a net 229,000 BOE/d this year, all of which is in the Lower 48. Antero Resources Corp.'s (NYSE:AR) vast hedging program that covers most of its ~300,000 BOE/d (23% liquids) in 2016E output (primarily dry natural gas) is a perfect example of how to properly shield your realized NGLs and dry gas prices (in America specifically) from a downturn. That hedging program will continue to cover most of Antero Resources' output heading into 2017, even as it grows its production base by double digits on the back of its strong hedging portfolio and solid Marcellus/Utica operations.

There are plenty of other examples to give, and to be fair, Antero and Pioneer's hedging programs do stand out above the rest, but the basic point is that ConocoPhillips should be able to hedge a material amount of its output. It won't be able to lock in the same kind of prices Pioneer Natural Resources and Antero Resources were able to, and that is due to ConocoPhillips' seeming inability to truly shed its integrated oil major mindset.

Downstream operations are the true hedge to lower oil/NGLs/natural gas prices, as refineries are able to buy crude cheaper (with gasoline prices slowly moving lower in the process) while petrochemical operations are able to source NGLs and natural gas feedstock at much lower prices. Without Phillips 66 (NYSE:PSX), ConocoPhillips needs hedges to preserve its operating cash flow streams during times of extreme volatility and change in the sector, such as the hydraulic fracturing revolution in America adding a significant amount of "unexpected" supply to the market.

Final Thoughts

Another Seeking Alpha author Michael Fitzsimmons brought up a similar point, and I couldn't agree more, ConocoPhillips' management team's attitude towards hedging is truly baffling. The segment that reported the largest loss for ConocoPhillips last year was its Lower 48 operations, yet management maintains that there isn't enough of a hedging market for a company of ConocoPhillips' size.

That doesn't appear to be true based on the ability of other producers like Antero Resources, Pioneer Natural Resources, EOG Resources, Inc. (NYSE:EOG) (128,000 bo/d hedged in Q2), and Chesapeake Energy Corporation (NYSE:CHK) (over 600,000 BOE/d in output with the majority of its 2016E dry natural gas and crude oil production hedged) to hedge their relatively large production bases to various degrees in North America. This is why many investors and shareholders are posing this question: Why isn't ConocoPhillips hedging, or at the very least hedging its Lower 48 production? Only time will tell if management eventually moves on this issue.

On a side note, getting back to my initial statement up above, there are other things to like about ConocoPhillips which interested investors can read about here, but its lack of a hedging program remains a major ongoing concern.

Disclosure: I am/we are long CHK.

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.