The lack of growth in shale production, currently inching higher but primarily from DUC- Drilled but Uncompleted wells, has been largely attributed to capital discipline. Shale companies have spoken almost in unison that the higher prices now being seen would not be enough to deter them from the balance sheet repair and shareholder returns strategy in lieu of growth that many embarked upon a year and a half ago. A factor that has not been widely reported is the level of hedging losses that are stripping away much of the upside presented by the current price scenario for WTI-West Texas Intermediate and Brent. In this article, we will look at the drivers for this strategy and what the impact may be to Pioneer and other shale companies that took similar steps.
Pioneer Natural Resources
Pioneer Natural Resources, (NYSE:PXD) sent a shockwave through the energy equity markets Tuesday with their pre-announcement of hedging losses to be booked for the second quarter. Pioneer, one of the largest Permian basin producers had hedged about 200K BOPD, about one-third of their daily production, at $40 per barrel. Their intent was to cushion a potential sell-off below that level, and guarantee they would stay in the black, thanks to their low break-even costs.
When prices for oil and gas moved higher as the year started, and then accelerated through the second quarter, the failure of this strategy becomes evident. The table above taken from the SEC-8K they filed on the 27th discloses hedging losses in excess of $1.5 bn for the first half of 2021.
Related: Analysts See Oil Trading Closer To $70 Through Year-End Now to a company generating the kind of cash flow that Pioneer is, this isn’t the end of the world. But it does raise questions as to how such a bearish strategy was implemented when the trend for oil prices began to improve, though modestly by mid-year.
Go back a year to July 2020. It was a vastly different world than the one that exists today. Many of us have forgotten how terrified we were. In the relative balmy period that has been operative since early November 2020 and the announcement of the vaccine efficacy, it’s been easy to forget that state of mind.
As noted in a Financial Times article, in those dark days of mid-2020, where the futures contract for WTI fell below $0.00 zero briefly, lenders were nervous about the viability of some companies and forced to them buy “insurance” against the wild fluctuations of the commodity. This insurance took a number of forms, but the most popular was to simply purchase a SWAP contract for future production.
SWAPS are a form of hedge that enables a producer to fix a price for their production in a particular forward month. If the settlement price is lower than the hedged price, then the producer books a hedging profit. If the inverse is true, then a loss is booked.
In PXD’s case, this insurance was provided by a series of SWAP contracts for various crude benchmarks, some of which had been taken out by companies bought by PXD-Parsley Energy, and DoublePoint Energy. With hedged prices in the low $40’s, when those contracts expired, PXD was forced to pony up the cash. A lot of it is shown in their 8K release.
In the case of PXD, there is good news and bad news. The bad news is that swap contracts are in place for their 2022 production at roughly $50.00 per barrel. The good news is that they have much less production locked in at that price than in 2021.
How this will act to keep a lid on shale production
There is more pain to be spread around as the 2nd quarter reporting season gets underway. According to the Financial Times, there are about 30 oil and gas firms with significant hedging exposure in 2021 and 2022. Among shale names widely held seeking protection against a downside are Devon, (NYSE: DVN), Diamondback Energy, (NYSE:FANG), Hess, (NYSE:HES), EOG Resources, (NYSE:EOG). None are as exposed to the size of the losses incurred by PXD in terms of volume and price, though.
The impact of these drains on cash reserves will be to keep the trajectory of new shale production fairly flat. The focus on the balance sheet will prevent companies from borrowing to expand their production. In their monthly shale newsletter, Rystad noted that only modest growth could be expected through the end of 2021.
“US crude oil output reached about 11.45 million bpd in June 2021. Despite the bullish conditions, it is only forecast to grow by 60,000 bpd to 11.51 million bpd in July, remaining at the same level in August. A constant, albeit slow growth trajectory will commence in November 2021, when crude output is expected to rise back to 11.55 million bpd, then closing the year with 11.62 million bpd in December. From January 2022 onwards output will continue to rise, breaking the 12 million bpd monthly average only from October that year.”
Shale companies are set to less hedging post-2021, assuming prices stay in the current high $60’s to mid-$70’s range. Scott Sheffield, CEO of Pioneer comments on how the hedging strategy will be modified-
“If you go back to the 2012, 2013, 2014 time period, oil price got up to $80 to $100. So I think it'd easily test those prices over the next few years. So we will probably do less hedging. If it gets up into that $75 to $100 range, you'll probably see us continue to do some hedging at that point in time to protect those profits, obviously, and support both the base and the variable dividend, but not as high as we've done in the past.”
In this scenario as oil demand increases a number of constraints are extant on increasing oil production. The OPEC+ nations are once again the swing producers, able to pump and withhold oil from the market as conditions dictate, thus setting the world price. U.S. shale producers have a number of disincentives to ramp production beyond incremental amounts that largely keep up with legacy well declines.
These factors will tend to make supplies tight over the next year or so, and support prices for WTI above $70 and Brent prices close to $80 per barrel. Once the low price hedges and swaps begin to fall off later this and in early 2022, shale producers will then have adequate cash flow to increase their production, adding still further to free cash flow thanks to the cost-cutting taken over the last several years.
Companies discussed above appear attractive at present prices and are seeing gains in current trading.
By David Messler for Oilprice.com
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