Oil Drillers Exposed in Three-Way Hedges

Oil at $30 a barrel is blowing a hole in the insurance that U.S. shale drillers bought to protect themselves against a crash.

Companies including Marathon Oil Corp., Noble Energy Inc., Callon Petroleum Inc., Pioneer Natural Resources Co., Rex Energy Corp. and Bonanza Creek Energy Inc. used a strategy known as a three-way collar that doesn’t guarantee a minimum price if oil falls below a certain level, company records show. While three-ways can be cheaper than other hedges, they leave drillers exposed to sharp declines.

QuickTake Oil Prices

"At the time people hedged, they did it without thinking that oil would go to $28," said Thomas Finlon, director of Energy Analytics Group LLC in Jupiter, Florida. "They didn’t have a realistic view about whether the market would crumble or not."

The three-way hedges risk worsening a cash shortfall for companies trying to survive the worst oil crash in 30 years. The insurance is all the more important after oil plummeted 43 percent in the past year to $26 a barrel in January, exacerbating the pressure on debt-burdened producers.

"In 2015, everyone was given a hall pass and had a little protection from hedges," said Irene Haas, an analyst with Wunderlich Securities. "But as we roll into 2016, the hedges aren’t as attractively priced anymore and the hedges aren’t going to exactly bail you out."

Shale Boom

The U.S. shale boom was built on high oil prices and low-cost financing, which enabled drillers to spend more than they earned while making up the difference with debt. With oil at a 12-year-low, financing is much harder to come by. Locking in a minimum price for crude reassures investors and lenders that companies will have the cash to pay their debts.

Joseph Gatto, Jr., Callon’s chief financial officer, told investors at a conference in December that the company had hedged about 4,000 barrels a day in 2016, or 40 percent of its projected output, at a price of $56 a barrel.

About half of those contracts are worth significantly less at $30 a barrel because Callon employed three-ways, Securities & Exchange Commission records show. While the company is guaranteed $58.23 for 364,000 barrels in the first half of 2016, or about 2,000 barrels a day, the remaining 364,000 have lost value because the strategy sacrifices protection when prices fall below $40.

Three Parts

The trade has three parts. First, one option capped the best price Callon could get at $65 a barrel. Selling the right to profit if prices rise offsets the cost of protecting against a decline. The second piece established a floor price of $55, a guaranteed minimum that Callon would get paid even if oil fell below that point. By itself, this kind of trade, called a collar, would’ve ensured that Callon received $25 a barrel protection when oil is trading at $30.

However, Callon added a third element by selling a put option, sometimes called a subfloor, at $40 a barrel. Below that point, Callon essentially forfeits part of its protection. Instead of pocketing $55, the company is only entitled to the difference between the floor and that subfloor, or $15 a barrel in this case. At $30, Callon will realize $45 a barrel, $10 a barrel less than it would’ve received with a traditional collar.

If prices rebound above the subfloor, any disadvantage to the three-ways disappears. Crude fell $1.75 to $27.94 a barrel Tuesday on the New York Mercantile Exchange.

‘Risk Management’

"Our hedging program is part of our broader risk-management efforts and is designed to provide downside protection in a falling commodity-price environment," said Eric Williams, a spokesman for Callon. The price of oil futures through 2016 is at about $35, at which Callon’s three-ways would yield $50 a barrel, he said.

Representatives for Marathon, Noble and Rex Energy didn’t return phone calls and e-mails seeking comment.

Similarly, Pioneer used three-ways to cover 65,000 barrels a day in the first half of 2016, or about a third of its projected output, company filings show. The strategy capped the upside price at $73 and guaranteed a minimum of $63, which would’ve ensured $33 above a selling price of $30. 

However, Pioneer added a subfloor at $43. If oil’s trading at $30 a barrel, Pioneer will get about $50, or the market price plus the $20 difference between the floor and the subfloor. The difference adds up. With oil at $40, Pioneer will realize about $845,000 less every day than it would have using the collar with the $63 floor.

Providing Protection

The protection is still significantly better than nothing. Last year, the company’s hedges brought in $875 million and they will pay off again in 2016, said Rich Dealy, Pioneer’s CFO.

"Over the past few commodity price cycles, we have learned the importance of using derivatives to protect margins and cash flow," Dealy said. "We actively manage the types of derivative instruments we use based on our outlook for prices."

Likewise, Bonanza Creek hedged 5,500 barrels a day for 2016, about 33 percent of its production, with three-way collars with a ceiling of $96.83 and a floor of $85. At $30, the trade would be worth about $55 a barrel, or $302,500 a day. However, Bonanza Creek also sold $70 puts, making its position worth just $15 a barrel, or $82,500 a day.

Ryan Zorn, treasurer and senior vice president of finance for Bonanza Creek, declined to comment.

"Nobody expected this kind of downward spike," said Haas, the Wunderlich analyst.