Crude oil price volatility: Hedging to rescue
Oil producers are taking advantage of the rebound in oil markets by locking in prices for next year and beyond, safeguarding future supplies concerned that the rally may fizzle out with US oil stockpiles at record highs.
This is coming as most upstream exploration and production players are forced to battle with the new reality of lower oil prices translating to lower revenue and operating cash flows. The flurry of hedging activity in the past month will help sustain producers’ revenues even if oil markets tumble again.
While the proportion of oil companies actually executing those deals is not that high, the deals thus far have been large in terms of volume and monetary value. With new hedges now, producers have found an opportunity to maximize cash flow by selling calls and protecting the downside.
For many companies that set up “in the money” hedges prior to the slump, the downturn offers a chance to cash in or extend their protection. Instead of just pocketing the cash, some companies are using the funds to shield themselves against a further market slide by buying swaps and options pegged closer to current prices.
Oil drillers are racing to buy protection for 2016 and 2017 in the form of three-way collars and other options. In some cases, that means guaranteeing a price of no less than $45 a barrel while capping potential revenues at $70.
A three-way collar involves buying a put option, which sets a floor for prices and selling a call option at a higher strike price, which caps gains in case of a rally but yields income that serves to offset the cost of the put options. In addition, the company sells another out-of-the-money put as well, which lowers the overall cost of the transaction but exposes the producer to greater risk if prices drop too low.
While there are signs that four years of rapidly rising US oil output may end next month and indications that consumption is picking up, some bearish factors cloud the picture, including Saudi Arabia pumping at record levels and a record US inventory overhang.
Against that backdrop, producers are offloading options contracts, such as the WTI December 2016 $60 call. Open interest in the contract has risen by 22 percent over the past five weeks while open interest for Brent December 2016 $75 call rose more than eight-fold in the last week.
Hedging help Oando reduce debt
Indigenous oil and gas producer, Oando plc, listed on both the Nigeria Stock Exchange (NSE) and Johannesburg Stock Exchange (JSE) recorded tremendous strategic success, as gains from its oil hedges facilitated the repayment of $238 million, out of its outstanding $900 million debt. The decline in prices has led to a substantial gain for Oando Energy Resources.
The company successfully realised $234million by resetting its crude oil hedge floor price from an average of $95.35 per barrel to $65.00 per barrel on 10,615 bbls per day for the next 18 months, according to Temilade Esho, an equity analyst with Investment firm Renaissance Capital, in a March 04 report.
The funds were earmarked for a $238 million loan pre-payment, thereby substantially reducing the company’s total debt from $900 million in August 2014 to $615 million, after the company had previously armortised some of the debt . Effectively, the company has managed to reduce its debt by 30 percent in the space of seven months post the acquisition of ConocoPhilips (COPN), Oando said in a statement.
“We see this as positive. Oando Energy Resources (OER) has been seen as leveraged and this huge cash inflow will reduce OERs current debt outstanding from $900m to $662m. This also saves OER $65m in interest payment over the remaining term of the loan,” said Esho.
A statement from the company indicates that the proceeds from the hedge and additional funds will be used in prepayment of certain loan facilities.
“The decline in global crude oil prices led to a substantial gain for our company and we have 10,832 bbls/day average productions hedged for the balance of 2015 and 8,000 bbls/day for 2016,” said Pade Durotoye, CEO of Toronto listed OER.
The hedge adoption effectively ensures OER receives income approximately pegged to a pre-agreed price, and enables it to conveniently service its debt obligations, which are denominated in both naira and USD, regardless of oil prices and without foreign exchange exposure, said the company in a statement.
FRANK UZUEGBUNAM