Oil and gas price shocks make producers hedge their bets with forward contracts

Companies hedge to reduce “their No. 1 risk,” that their oil and gas will be worth less in future than it is now (Pixabay Photo)

CALGARY — Like gamblers who have been burned too often, Canadian energy producers are lining up to “hedge their bets” on oil and gas by locking in price contracts today for deliveries to be made months or years from now.

Observers say more companies than ever are hedging future volumes, shocked by events like this week’s plunge in benchmark American oil prices from three-year highs above US$65 per barrel, as well as memories of the collapse to below US$30 in early 2016.

Hedging is a tactic used by energy producers and consumers to limit future price volatility. Producers sell contracts called “futures”, which consist of an agreement to sell some portion of a commodity at a set price. They can also offset potential losses through taking financial positions in the options market that are equal and opposite to their own holdings.

Futures allow both producers and consumers to limit risk linked to energy prices, giving them a stronger foundation on which to budget and plan for the future.

Companies hedge to reduce “their No. 1 risk,” that their oil and gas will be worth less in future than it is now, said Andy McConn, a Houston-based analyst for the company.

“A lot of these companies have long-term objectives predicated on prices of $50 or $55,” he said. “So when prices get above that, it gives them an opportunity to say, ‘OK, we’ll lock this in, that will give us confidence to budget and plan to hit these strategic targets.”’

He said producers want to make sure there will be money in the bank before signing deals with contractors and suppliers — and their bankers want the same assurance.

“I think producers in general for years in Canada shied away from hedging because it was never rewarded,” said Martin King, a commodity analyst at GMP FirstEnergy of Calgary, in a recent interview.

“But I think the investment community and producers are starting to wrap their arms around the idea of hedging more barrels, or molecules of gas, simply because they have to. You have to show yourself as being more financially capable, guard the bottom line, guard cash flows, guard capital expenditure programs.”

A Wood Mackenzie analysis of hedging activity by 33 of the largest global upstream companies with active programs found that they had added about 900,000 barrels per day of new oil hedges in the third quarter of 2017, up 150 per cent from the previous quarter and the highest volume of hedges added in a single quarter since at least 2015.

The simplest hedging contracts are for physical delivery and are struck between the producer and the consumer, an oil refinery or a natural gas utility company, for instance. The deals guarantee future supply at a set price.

Other hedges are financial contracts where the commodity doesn’t actually change hands and the deals are usually “settled” before their due date.

After one of the most volatile years ever for natural gas pricing in 2017, CEO Darren Gee of Peyto Exploration and Development said his mid-sized Calgary gas company has become much more defensive.

“Three or four years ago, we might have hedged 50 per cent.

Now, we’re targeting closer to 80 to 85 per cent,” he said. “We’re not trying to win or lose on the strategy. It’s just smoothing out what we see to be more extreme volatility in the natural gas price.”

Other Calgary producers including Encana Corp. and Crescent Point Energy Corp. are also active hedgers.

On the other hand, Suncor Energy Inc., Canada’s largest oil, gas and refining company by market capitalization, doesn’t hedge at all.

Spokeswoman Erin Rees said the company is protected by its integrated business model — when oil prices are low, profit margins at its refineries tend to grow because of the cheap feedstock.

There’s a lot at stake. In a recent report, RBC Capital Markets analyst Greg Pardy pointed out that because oilsands giant Canadian Natural Resources Ltd. doesn’t hedge, a US$10 per barrel change in benchmark oil prices could make its 2018 cash flow — a key measure of its ability to fund future growth — rise or fall by 36 per cent or $3.3 billion.

The Alberta government doesn’t hedge, either, although the royalties it collects from producer companies are paid “in kind,” literally with the equivalent of barrels of oil and cubic feet of gas.

Its royalty revenue from non-renewable resources (oil, gas and coal) has varied from $11.6 billion in 2011-12 to $2.8 billion in 2015-16. It is forecast to earn $3.85 billion in the current fiscal year.

Alberta Finance spokesman Mike Berezowsky said the government instead accounts for the possibility of lower-than-projected resource revenue with “a risk adjustment factor” — it subtracts US$10 per barrel from the private sector oil price forecasts it uses when making assumptions for its annual budgets.

Tim Pickering, founder of Auspice Capital in Calgary, said refusing to hedge prices has cost the Alberta government “billions” in lost revenue.

Under Alberta’s sliding royalty model, it collects fewer barrels of oil when the price is low, which means it “kinda gets hit twice” when prices tank, he said.