A Side By Side Comparison Of The Top Hedge Books In The Small Cap E&P Sector.

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Includes: BBEPQ, MEMP, NOG, SN
by: Salvador Garcia

Summary

A strong hedge book will be key for the survival of small cap E&P companies.

In order to properly understand the degree to which a company is hedged it is important to differentiate between different hedging strategies, i.e., swaps, collars, puts.

A strong hedge book will be key going into spring and fall redeterminations.

MEMP, BBEP, and NOG have some of the top hedge books in the industry.

While there are many factors that affect the viability of small cap E&P companies; I believe small cap E&Ps must have a strong hedge book in order to survive the current decline in oil prices. In this article I will provided an analysis of what I consider some of the top hedge books in the industry and provide estimates for average price per barrel of oil, average price per MMBtu of natural gas, and average price per barrel of NGLs that will be received by these companies for calendar year 2015, 2016, and 2017 (including the effect of hedges). At the end of the article I also include a bad hedge book for comparative purposes.

E&P companies execute different hedging strategies in order to provide cash flow stability. The most popular hedging strategies used by E&P companies include swaps, two way collars, three way collars, and long put positions. Each one of these strategies has different return characteristics that must be understood in order to appreciate the true depth of coverage an E&P company possesses.

Below is a spreadsheet I compiled displaying different payoffs offered by different hedging strategies at various oil prices.

As evidenced in the spreadsheet above different hedging strategies offer massively different levels of protection. For example, if oil is at $50/Bbls a company holding a $90/Bbls swap will receive a payoff twice as large as a company with a $70, $90, $110 3 way collar. So, even if a company claims to have a large percentage of their production hedged the hedges might not provide adequate support if oil is below certain thresholds.

Below I will discuss the hedge portfolios of various E&P companies that I consider have strong hedge portfolios.

1.) Breitburn Energy Partners (BBEP)

Below is a snapshot, provided by Breitburn, of Breitburn's hedge portfolio.

Below are the actual hedges Breitburn has in place based on Breitburn's 2014 10k.

As you can see in the charts above while Breitburn Energy Partners does have some collars these collars where executed with very high floors and provide excellent coverage.

Based on their production guidance of 19,500 - 20,700 Mboe I generated a spreadsheet below that estimates the average price Breitburn will receive for their oil and gas production during calendar year 2015, 2016, and 2017 (I assume $50 dollar WTI, $55 Brent and $3.00 Henry Hub natural gas. I also ignore price differentials).

(Prices below are quoted in Price/Bbls for oil and NGLs and Price/MMBtu for natural gas)

As evidenced in the spreadsheet above even under current price conditions BBEP will continue to receive favorable prices for their oil and gas production until calendar year 2017.

2.) Memorial Production Partners LP (NASDAQ:MEMP)

Below is a hedge summary of Memorial's hedge portfolio.(The chart below was provided in Memorial's investor presentation dated 03/05/15)

Below is the hedge schedule provided in Memorial Partners 2014 10K.

It is important to note that has strong hedges lasting well into 2019 and hedges basis risk as well as commodity risk resulting in what I believe to be the strongest hedge book in the E&P sector.

Based on MEMP's 2015 production guidance I estimated the average price MEMP will receive for their oil and gas production during calendar year 2015, 2016, and 2017 (I assume $50 dollar WTI, $55 Brent, $17/Bbls of NGLs and $3.00/MMBtu Henry Hub natural gas I also excluded differentials).

(Prices below are quoted in Price/Bbls for oil and NGLs and Price/MMBtu for natural gas)

As seen in the table above thanks to its hedges Memorial Production Partners will be able to realize a price/Bbls of oil above $80 a barrel for the next three years even under the current price environment. In fact, 2015 hedges are so strong that assuming oil went to $1/Bbls they would still receive over $80/Bbls for their entire 2015 oil production. Natural gas prices will also remain strong well above $3.50/MMBtu through 2017 ($3.50/MMBtu is a level I consider key for profitability for most shale gas producers).

3.) Northern Oil & Gas Inc. (NYSEMKT:NOG)

The chart below was provided in NOG's investor presentation.

The chart below was provided in NOG's FYE 2014 10k.

As evidenced in the chart above (NASDAQ:) does not have any hedges in place to protect its natural gas or NGL production. However, it is important to note that NOG receives less than 6% of its revenues from natural gas and NGL sales.

(Prices below are quoted in Price/Bbls for oil and NGLs and Price/MMBtu for natural gas)

As you can see in the table above NOG will be well protected from low oil prices during 2015 but will face difficulties if prices do not rise by mid-2016. Additionally, it is important to understand NOG operates by taking working interest in wells other companies are drilling rather than actually drilling the wells themselves. This results in different overhead and different profit margins than a traditional E&P company. I believe NOG's structure provides more flexibility in its capex; therefore, allowing NOG to operate in a lower price environment. Lastly, during 2014 NOG received $6.38/MCF for their Natural Gas and NGL production. However, without a more in depth breakdown of their production it is very difficult to compare NOG's gas production to other E&P's gas production, estimate future prices, and estimate profitability (Given that they did not hedge their gas production I would assume their gas production is unprofitable but it's impossible to know without more disclosures).

Example of a poorly hedged E&P.

Sanchez Energy Corporation. (NYSE:SN)

The chart below was provided by Sanchez in their April investor presentation.

As seen in the chart above Sanchez Energy claims to have hedged 60% of their oil and gas production for 2015; however, many of the hedges in place have sub floors or were executed after the decline in crude oil began. These actions have left (SN) very exposed to commodity price declines.

As seen above most of Sanchez's hedges have sub floors or were taken at unfavorable prices. Below you can see the result of these poor decisions.

(Prices below are quoted in Price/Bbls for oil and NGLs and Price/MMBtu for natural gas)

Sanchez Energy claims to have hedged approximately 80% of their oil production. However, as seen in the chart above Sanchez Energy will receive less than $70/Bbls during 2015 if the price of WTI remains at current levels ($50/Bbls). BBEP claims to have hedged only 75% of their oil production for 2015, yet will receive over $80 per barrel at current prices. In fact, a company that hedged just 45% of their oil production using straight swaps at $90/Bbls would receive a better average price per barrel than Sanchez. This clearly shows how Sanchez despite having hedges in place for a large portion of their oil production is not well protected from the current drop in commodity prices. Sanchez however will receive modest pricing for its natural gas production through 2016 which will provide slight support.

Conclusion

While a company's strong hedge portfolio is not enough to guarantee a company will survive the current drop in energy prices. I do believe small cap E&P companies will not be able to survive without strong hedge positions. Additionally, of the companies mentioned above I believe only MEMP offers value at current price levels. While I believe BBEP and NOG will survive thanks to their hedge positions they must resolve additional issues in order for me to consider them as potential longs. Further, given the current commodity price environment I do not believe the energy complex offers a compelling value opportunity at current equity prices. I would like to wait for a further decline in energy stocks before considering initiating a long position in the space.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.