The past performance is no guarantee of future and thus the oil exploration and production companies use hedging to manage their market risk. Hedging can be considered as something analogous to taking an insurance policy. Thus, when oil companies hedge an investment, they actually reduce the risk of adverse price movements. There is a risk-reward trade-off that is inherent in hedging. Thus, while it reduces potential risk, it also chips away some potential gains. But for the management to sleep peacefully and the shareholders and bankers of the oil companies to breathe easy, hedging is a must.
The oil prices have been on a roller-coaster ride in the past few years and the approach of the companies to use hedge has also undergone a drastic change. The hedging activity was at its peak during the shale boom, then saw a lull when oil prices crashed and is again on the rise.
We can summarise the hedging activity of the last ten years in three phases.
- In 2007-2008, the prices were peaking and so did the supply. Everyone was of the opinion that the prices will only rise and thus the hedging was minimal. The main focus of oil companies was on fracking of natural gas.
- Then came the phase of 2009-2014 when oil prices crashed and rebounded. The focus of the companies moved back to fracking of oil. The count of oil rigs increased and so did the hedging.
- From 2014 till date, the prices are coming down and the drilling activity is decreased. OPEC is trying its best to stabilise the prices and the companies have heavily hedged to reduce the pain.
Two from Bloomberg Intelligence, Peter Pulikkan and Matt Hagerty have actually released a survey covering data from 37 E&P companies that are together responsible for pumping 4.2 million barrels a day.
In 2014, the first shale wave was completed and the 12-months forward oil price was hovering around $100 a barrel, but when E&P started drilling again in early 2016 the price had come down to the range of $50 – $55. It even went below $50 creating a wave of panic among the oil companies.
The hedging survey taken by Bloomberg Intelligence indicated that 32 companies out of the 37 have hedged their anticipated oil production for 2017. Nearly 43% of this output is hedged at $50. If we talk of Permian shale basin, some 12 E&P companies that were included in the survey have hedged nearly 64% of the anticipated output at $49.43 a barrel weighted average. For one or two, this price comes even lesser at $47 a barrel.