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Irina Slav

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Cautious Hedging Costs U.S. Drillers Billions

A month ago, ConocoPhillips warned it would book a $600-million impairment to its first-quarter profits from its acquisition of Concho Resources and, as Reuters reported at the time, related oil price hedges. Now, it is emerging that Concho is not the only one that hedged too early.

When the price of crude oil began to recover last year after a devastating first half of the year, U.S. oil producers began to hedge their 2021 output at higher prices. They hedged less than normally, Rystad Energy noted in an October report, at 41 percent of their forecast production in 2021. But they hedged this at an average of $42 per barrel of crude. That compared with a bottom hedging price of $56 per barrel for 2020 production Rystad said in its report. Then prices climbed higher but, it seems, many oil producers continue hedging at low prices into 2021.

Now, U.S. oil companies are facing billions in missed opportunity losses, Reuters reported this week, because of this overly pessimistic hedging. The report quoted the co-head of commercial intelligence of energy data at Enverus, Andrew McConn, who said some 66 oil producers had accumulated missed opportunity losses of as much as $7 billion for the first quarter of the year.

Hedging at around $40 per barrel obviously made sense in late 2020 and early 2021. Uncertainty about oil demand, despite the production-cutting agreement of OPEC+, continued high as global Covid-19 infection rates also stayed high and are rising fast. This uncertainty remains. Oil prices recently suffered a decline because of the surge in infections in India.

Yet, in hindsight, it appears that many U.S. oil companies overestimated this uncertainty and the risks it carried for their oil production. Diamondback Energy hedged some of its output at a little over $46 per barrel and now expects losses of some $102 million, Reuters reported. Cimarex, for its part, said it would report hedging losses of $162 million for the first quarter. Chesapeake Energy will also likely post hefty losses as it hedged some 19 million barrels of future production at a price of $42.69 a barrel. Related: Oil Prices Climb As OPEC+ Holds Firm On Output Cuts

Meanwhile, World Oil reports that oil companies are beginning to hedge their output further into the future than normally. A survey among the 30 largest public E&Ps in the United States revealed that although most companies hedged only their 2021 output, some made hedges on output to be produced as far in the future as 2023 and 2024. As for prices, the average price of WTI at which the companies hedged was $44.69 per barrel for 2021 production and $43.88 per barrel for 2022 production.

The numbers confirm that a lot of companies hedged cautiously and have, as a result, suffered losses either from unwinding these contracts or from missing the opportunity to make more money from their barrels. Whether this cautiousness will subside this year, however, remains to be seen. Oil prices are certainly higher, but so is the global production of oil. And it might grow higher still if OPEC further relaxes its output curbs, unlikely as this is at current prices.

The good news, according to analysts, is that few if any oil companies hedge all their output. While this is confidential information for most of E&Ps, a handful of participants in the World Oil survey disclosed the amount of output they'd hedged, which was an average of 80 percent, including three-way contracts believed to be safer than two-way ones.

Yet most producers hedge a lot less than this, one analyst who spoke to Reuters said. The average is about half of annual production, and with the right ratio, the hedging company could still make money from the barrels it didn't hedge in case it hedged at too low prices.

"If you have the appropriate hedge ratio, you should want to lose money because you're making money on the other part of your portfolio," John Saucer from commodity advisors Mobius Risk Group said.

By Irina Slav for Oilprice.com

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