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The Risk Oil Drillers Couldn’t Hedge Away

Failing drilling companies lose valuable insurance that would protect them against falling oil prices.

To provide themselves a cushion against sharp drops in oil prices, drilling companies often buy hedges—financial contracts that pay off when prices fall. Now a quirk of bankruptcy law has stripped some shale drillers of that insurance just when they need it most.

Houston-based Linn Energy, for example, bought contracts that guaranteed a price of $90 a barrel, even if prices were lower. It paid off: By the end of March, with oil below $45 a barrel, Linn’s hedges were worth $1.5 billion, making them among the company’s most valuable assets.

The hedges weren’t enough, however, to keep Linn out of financial trouble after the oil price plunge. This put Linn’s lenders, a syndicate of more than 20 companies, in an odd position. Linn owed them $4 billion and was about to go into bankruptcy. Yet some of those same lenders—it’s not clear which ones—were also on the other side of Linn’s hedges, paying $100 million per month to Linn to settle the contracts as they came due. Put simply, Linn’s bankers had two losing bets at once.

Then came the solution. In the weeks leading up to Linn filing for bankruptcy protection in May, its oil and gas hedges were sold off for their market value. The resulting $1.2 billion in cash was applied to paying off its loans. Linn agreed to the sale, but if it hadn’t, bankruptcy law would have allowed the lenders to seize the contracts anyway.

That’s unusual. Bankruptcy law typically stops creditors from foreclosing on the property, such as land and equipment, of companies that are about to fail. The rules are meant to ensure that companies have a chance to restructure and that assets are divvied up fairly among various creditors.

But there’s an exception for assets in the form of financial derivatives such as hedges. It’s designed to keep trading losses from spreading when a company goes under. The same exemption came into play when Lehman Brothers went under in 2008. It allowed other Wall Street banks to collect billions on trades with Lehman, though not without controversy. Eight years after the collapse, some investors are still fighting over the trades in court.

When lucrative boom-era oil trades are liquidated, banks ensure they get some of their money back, but companies are left without a vital cash lifeline. “These hedges are a huge part of the economic value of these oil and gas companies,” says Jeff Nichols, a partner specializing in energy finances for law firm Haynes & Boone. “And they are exempt from the bankruptcy code.”

A renewed slump in oil—a barrel of crude is back below $45 after rallying to almost $52 in June—means even more pain for bankrupt companies that have had their hedges closed out, including Linn, Penn Virginia, and Energy XXI. The sale of Penn Virginia’s hedges raised about $40 million, most of which was applied to its bank loan, and Energy XXI’s were liquidated for $50 million. Representatives of all three companies declined to comment.

“By selling all the hedges now, they’re left burning cash,” says Gurpal Dosanjh, an energy analyst with Bloomberg Intelligence. “If oil prices don’t recover in the next few months, they’re not going to be able to get out of bankruptcy.”

Other shale drillers may be at risk. Halcón Resources, which is negotiating with creditors and has said it may file for bankruptcy by early August, has long had some of the best hedges in the business. Its records show it still has contracts paying as much as $85 a barrel for 80 percent of its 2016 output. The company had no comment.

Companies that lose their hedges are “naked against the market prices,” says Jason Wangler, an analyst at Wunderlich Securities. With prices almost 60 percent below where they were in the early 2010s, that’s a level of exposure no one wants.

The bottom line: During the oil boom, drillers bought hedges against falling prices. But banks can foreclose on those contracts.

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