Some Oil Producers Have Secret Weapon in Hedging

Not all oil companies are equal when it comes to the pain of sharply lower crude prices. Some companies and national producers around the world bought insurance-in the form of hedging strategies-for just such a collapse.

This hedging tool kit allows some companies such as Hess Corp. HES 5.82% and Cairn Energy CRNCY -2.29% PLC and countries including Mexico to continue selling their crude at considerably higher prices when benchmark U.S. and global oil prices plummet.

Hedging isn’t a cure-all. It is complex and expensive, but for some the strategies provide a bit of short-term comfort.

Hedging contracts lock in a price for a certain volume of oil that a company plans to deliver within a specific period, often for as much as three years from the date of the contract. If market prices drop below the agreed-upon or “strike” price of such deals, a bank or other counterparty to the hedge agrees to cover the difference.

It can be a risky gambit because hedgers pay banks and oil companies to insulate their prices against market fluctuations-and they can lose money when prices jump.

As the Saudi-led Organization of the Petroleum Exporting Countries hashed out a historic deal with the U.S., Russia and other oil-producing nations this month, Mexico nearly scuttled the agreement, resisting OPEC’s demands that it join in an emergency production cut.

Unlike other countries in the negotiations, America’s neighbor to the south has profited handsomely from oil’s pandemic-driven price rout.

The deal saw Riyadh, Moscow and Washington agree to lead a coalition of oil exporters in keeping 13% of global supply off the market. Mexico eventually decided to join in. Yet the pact, the biggest ever of its kind, has failed to spur a significant price rebound as the coronavirus pandemic saps oil demand.

On Friday, Brent crude oil was up 2% at $21.77 a barrel and WTI futures are up 2.3% at $16.89 a barrel in a volatile trading week. On Monday, U.S. oil to be delivered in May ended trading at negative $37.63, after closing last Friday at $18.27 a barrel. That effectively meant that sellers had to pay buyers to take barrels off their hands.

On Tuesday, the U.S. oil contract for delivery in June tumbled 43% to $11.57 a barrel, its lowest close in 21 years. Its record low is $10.42 in data going back to 1983. Brent crude, the global benchmark price, has dropped 68%.

Mexico’s hedging allows it to sell oil at $49 a barrel. The trade, called the Hacienda Hedge, has been around since the 1990s, helping to insulate government budgets from commodity market fluctuations. In the past, the Mexican government has paid as much as $1 billion a year in options negotiated with banks and oil companies. President Andrés Manuel López Obrador said Wednesday that the hedge would allow the country to reap a $6.2 billion windfall.

“We protected the Ministry of Finance,” he said. “We won’t lose money due to the oil-price drop.”

In recent years, Iraq’s State Organization for Marketing of Oil and the Abu Dhabi National Oil Co. in the United Arab Emirates have considered hedging but gave up on the idea after balking at the complexity and costs of the transactions and reviewing projections that suggested prices were headed for a steady rise, according to officials in these countries.

The practice is common among independent North American oil producers. These companies don’t enjoy the financial cushion that most major oil companies have and typically rely on high prices to keep pumping.

A third of North American oil exploration and production is hedged at an implied sales price of $52 a barrel, according to IHS Markit.

New York-based Hess Corp. says it has hedged about 80% of its oil production, most of it at $55 per barrel for West Texas Intermediate, the main U.S. benchmark. That means the company will make a profit on most of the 200,000 barrels a day it plans to pump this year and will be able to fund its contribution to an 8-billion-barrels Guyana project led by Exxon Mobil Corp.

Thanks to its hedging program, spending cuts and a new loan, “our company is well positioned for this low-price environment,” said Hess’s Chief Executive John Hess in mid-March. “Our focus is on preserving cash and protecting our world-class investment opportunity in Guyana.”

Laredo Petroleum Inc., of Tulsa, Okla., and SM Energy Co., of Denver, said they have their production hedged at WTI prices of $59 a barrel and $36 a barrel, respectively. Oil and gas independent Antero Resources hedges most of its production, and recently said it would cut 13% of spending, while maintaining its output guidance in the U.S. and Canada.

Southwestern Energy Co. of Spring, Texas, another company with a significant hedging strategy, predicted recently that its oil production would increase by 25% this year.

In the North Sea, Cairn Energy says it will be able to maintain its output of up to 23,000 barrels a day after hedging its production at $62 a barrel. Africa-focused Tullow Oil PLC said in January that it had hedged the equivalent of 45,000 barrels a day-more than half its expected output of 75,000 barrels a day this year, at a minimum of $57.28 a barrel.

Now hedging is virtually unavailable to companies that are looking to mitigate losses from the price crash. “The downward shift in the curve and the increase in volatility will make it much more challenging to add hedges for the remainder of 2020,” IHS said.

By Benoit Faucon