Oil companies lock in prices to avoid volatility. That can mean missing out on millions

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Wild swings in oil prices have wreaked havoc on energy company finances in recent years, prompting several to lock in their price to avoid further shocks. However, those price hedges have been a boon to some companies and a curse to others.

Hedging has cost some companies hundreds of millions of dollars, while protecting others against deep losses and pipeline congestion.

“There’s definitely some guys that probably hedged too low and others that are sitting pretty,” said Martin King, a commodities analyst with GMP FirstEnergy, an energy-focused investment bank.

Anyone working in the oilpatch knows how volatile commodity prices are and how fickle the markets can be. When prices are sliding, do you lock in your future production to avoid further price erosion or roll the dice by gambling that prices will recover and surge higher?

Big bet on oil prices

Calgary-based Cenovus faced that decision in May 2017. The company had just acquired a massive swath of assets from ConocoPhillips in a $17.7-billion deal. Oil prices were falling and Cenovus didn’t know when it would sell off some of the properties it had to help shore up its financial picture.

Cenovus hedged. Big time.

Fast forward to today and the results of the company’s decision are pretty clear. In the first quarter of this year, about 80 per cent of the oil produced was locked in at a price well below where oil is currently selling, costing the company dearly.

Cenovus announced a $469-million realized hedging loss for the quarter — the amount it would have earned without hedging.

The figure shows how much is at stake for large oilpatch producers as they contemplate signing these future contracts.

CEO Alex Pourbaix says the company hedged too much of its oil production. 1:27

Hedging typically involves limiting price volatility through the futures market that offers oil and gas contracts to be bought or sold at a certain price. Like insurance, a hedge could set a price floor if commodities lose value.

Producers can offset potential losses through hedging, but risk losing out on gains if prices rise. It’s all about speculation on where commodity prices will go. Considering how erratic prices can be, hedging provides some level of financial certainty.

For Cenovus, the hedges only start to come off in the third quarter, when about 37 per cent of production will be locked in at the lower prices.

‘”The company made a decision to execute this really significant hedge book related to this ConocoPhillips acquisition,” said chief executive Alex Pourbaix, who took over the helm of the company in November, in an interview with CBC News.

“Certainly [from] my perspective, we should not ever be this hedged going forward,” he said.

“The best defence by far against volatile commodity pricing is a very strong balance sheet. To the extent that the company’s balance sheet is stronger, it would significantly reduce the financial risk we are trying to protect against with a hedging program.”

Hedge on oil and gas

Commodity price vagaries are also why Encana signed future contracts for some of its oil and gas production in both Canada and the United States. The company is relishing its decision.

Encana oil production in Texas and its natural gas production in Alberta are both at risk of selling for a discount because of pipeline constraints. Gas prices in western Canada have been especially poor recently, even turning negative last summer

Canada’s natural gas industry faces several challenges as prices languish. (Philippe Morin/CBC)

The hedges ensure Encana receives better prices and avoids the pipeline mess.

In Texas, the company would be facing a $10 to $15 US discount without the hedges, according to a research note by Altacorp Capital.

“While this is concerning, investors should know that Encana is fully insulated from this differential in 2018 and is >90% hedged in 2019,” said the note from AltaCorp Capital analyst Nick Lupick.

The company’s natural gas hedges extend into 2020.

While experts say there has been an increase in hedging in recent years, some organizations do not hedge at all. 

Suncor does sign future contracts because when oil prices fall, the company’s refinery business is more profitable and balances out the reduced revenue from crude.

The Alberta government also resists hedging for the oil it receives from companies as royalty payments. The government has discussed it in the last decade but it hasn’t received enough support. Considering the millions of dollars at stake, the financial risk can be too politically unsafe.

SOURCE: CBC.ca

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