U.S. Shale's Big Hedge And The Hidden Danger

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Includes: PXD, SN
by: Clayton Rulli

Summary

Us Shale keeps plummeting and it seems hedges are the only crutch helping explorers.

Some hedging programs offer only some comfort if oil continues to fall.

Below $70 becomes quite burdensome for many US shale developers considering the instruments used as hedges.

In a recent article covering Pioneer Natural Resources (NYSE:PXD), I briefly summarized an impressive 2015 oil hedging program covering 85% of volumes, which surpasses that of many competitors in the space. In my research I came across a slide from the December 2014 presentation, explaining the concept of a 3-way collar, which are popular hedging mechanisms among US shale players.

This strategy can be difficult to understand for investors unfamiliar with options, but in a nut shell a producer uses these strategies to mitigate commodity price risk for little or no cost. Typically, the company will place a cap on their max oil price realization for a credit, then will use this credit to purchase put spreads, thus mitigating the put spread expense. The put spreads offset a decline in commodity price, but only from the long put price point down to the short put price.

The advantage of this strategy is an exceptionally low cost to obtain this protection even if they are not needed. Thus if prices do not drop, the company doesn't take a loss on their unused hedges. In the example above, the max commodity price achievable is $135, while the downside is protected from $90 down to $75. While the $15 range from $90 to $75 is offset by this 3 way collar hedge, losses below $75 are less mitigated. Basically, if oil is anywhere in the range of $90 to $75, the company can sell oil for $90, which is a huge benefit. However, I would argue against the graph and say that prices below $75 are a huge burden.

The graph shows a "potential gain" of +$15 if oil is anywhere below $75, but really that is where losses begin to accrue again. For instance, say oil is at today's price of $68. Net of the 3-way collar shown above, the net price is $83. This is a great help, however the disadvantage of this cheap 3 way collar is if oil continues to fall the company will realize lower and lower prices. In essence, the short put of the collar in this example at $75 did lower the initial cost, however it does also limit the protection of the hedge if prices drop.

So what's my point you ask? My point is when a company boasts of what percentage of future production is actually hedged, some investors do not realize many of the hedges used are 3-way collars or similar put spreads, both of which limit downside protection. Therefore, the percentage volumes hedged are indeed hedged, but only above a certain price, thus can be a little misleading.

For example, let's look at Sanchez Energy's (NYSE:SN) hedging book, from their recent Q3 2014 10-Q SEC filing. The 3-way collars are below:

For 2015, 1.825 M barrels appear to be hedged via 3 way collars, with an average long put price of $87, and an average short put price of $72. Similar to the PXD graph above, losses on oil prices are cushioned from 87 down to 72, thus compensating for the current price of $68 or any price below $72 for that matter by $15.

However, Sanchez does have additional oil hedging totaling 1.4 M barrels via swaps for the period, shown below:

Thus, we can presume 56.5% of SN's oil hedges for 2015 only cushion oil pricing by 15$. While the other 43.5% of hedging, or swaps, are more effective, the numbers are still quite disturbing. If we consider just 41% of 2015's oil volumes are hedged to begin with, the effectiveness of SN's hedging program begins to approach the realm of ineffective.

To crunch the numbers and summarize SN's situation in total, since 41% of 2015's midpoint oil volumes are hedged, and 56.5% of that is hedged by only $15 in a worst case scenario, that means 23% of total 2015 volumes are hedged by just $15 if oil stays below $72, and just 17.8% of total volume is hedged by more effective swaps.

Obviously Sanchez is not alone, because many exploration companies are in the same situation. It's a fact that while many are under hedged, the smallish portions of volumes that are actually hedged and that were thought to be safe, are only minimally protected if the black swan does arrive and oil falls further.

The hard truth is these put spreads and 3 way collars only guard against a small to medium drop in oil, and any meaningful price drop below the short put price is where losses will begin to mount. The lesson to be learned here is even though a company boasts of a hedging program safeguarding a reasonable percentage of oil volumes, really not all hedges are created equal in a black swan event like we are seeing. This is just one reason why US Shale is threatened and is being violently sold.

Disclosure: The author is long SN.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.