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Hedges & Harold - A Half A Billion Dollar Gamble?

|Includes: Continental Resources, Inc. (CLR)

In hindsight, cashing in on oil hedges might not be the best decision Harold Hamm has taken in his career. In this post, the impact of exiting these derivative positions on Revenue and EPS numbers in Q4 2014 and throughout 2015 is assessed. A recent WSJ article put the revenue loss in Q4 due to exiting these hedges at $125 million, whereas CLR has indicated that the number is much lower. While exact month to month losses are hard to predict with publicly available data, the total aggregate reduction in revenue can be calculated very accurately as shown below.

Here are the positions that Continental (NYSE:CLR) held at the end of Q3, which it subsequently cashed out during October.

  Swaps (bbls) Avg. Price Collars (bbls) Avg. Price (floor)
Oct - Dec 2014 WTI 3,335,000 96.2 - -
Oct - Dec 2014 Brent 4,508,000 103.2 552,000 90.8
Jan - Dec 2015 WTI - - 4,380,000 87.0
Jan - Dec 2015 Brent 24,637,500 100.8 730,000 95.0

In their Q3 earnings call, CLR announced that they exited these positions for a gain of $433 million. Since most of these swaps and collars were in-the-money during October, the blended average selling price of these derivatives can be calculated.

  • Average selling price of the hedge positions ~ $85 per bbl

Note that, during this period from Sep 30 - Oct 31, price of crude oil (NYSE:WTI) moved from ~$90 to $80. (For the price of this calculation, price of Brent crude is fixed at (WTI + $3). This assumption does not have any material impact on the blended average selling price and on the overall analysis)

Impact in Q4 2014

Assuming that for the reminder of December WTI will be in the range of $60 - $65 , the average price of Crude Oil (WTI) during Q4 will be around $75.

Thus removing hedges will result in

  • Reduction in Q4 revenue : $84 million

  • Reduction in Q4 Net income : $53 million

(Note that the revenue would have directly translated into Net income (net taxes). Production expenses, production taxes and DD&A will not be affected by these positions.)

Impact through 2015(beginning of Q4 2014 thru end of 2015)

A similar analysis can be run to show the impact of crude prices on revenues through Q4 2015. Plots below show the decrease in revenue, Net income and EPS with variation in crude prices (WTI).

If crude prices average $70 next year,

  • Revenue decrease : $530 million

  • Net Income decrease : $334 million

  • EPS decrease : $ 0.93 /share

It is clear that the pain will be significant if crude prices drop further. If crude prices average $60 in 2015,

  • Revenue decrease : $ 827 million

  • Net Income decrease : $ 521 million

  • EPS decrease : $ 1.45 /share

An improvement in global economic growth outlook, OPEC decision to curb supply or other unexpected disruptions in supply could certainly alter these calculations.

For now, it looks very unlikely that this gamble will pay off. The real question is whether it will cost CLR half-a-billion dollars or much more.

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