As price hedges wear off, some shale firms may finally break

By Saqib Rahim | 08/27/2015 07:59 AM EDT

U.S. shale companies bought insurance in case oil and gas prices wobbled. They didn’t prepare for this.

That’s why some on Wall Street believe these companies will soon cry "uncle."

As 2015 nears its end, the argument goes, shale firms will exhaust the price "hedges" that have protected them thus far. Between that, and all the other financial stresses, they may finally be forced to cut oil output and pave the way to a price recovery.


U.S. exploration and production firms (E&Ps) have hedged 21.2 percent of their oil output this year, according to RBC Capital Markets. For next year, they’ve so far hedged only 10.1 percent of output.

Oil markets have hoped all year that these companies would cut their output. Somehow, they’ve managed to do the opposite. They have slashed costs and strained their balance sheets in the hope of surviving until prices rise (EnergyWire, Aug. 13).

"I’m not even kidding here. Somehow we were duped," Carl Larry, an oil and gas consultant with consulting firm Frost & Sullivan, said by email.

"Back a few months ago when I was preparing for the death of oil producers to come on a weekly basis like characters on ‘Game of Thrones,’ we have been thrown a plot twist," he said. "It seems that producers are breaking even at a lot lower levels than once thought."

It’s also become clear the oil crash will last beyond 2015. Bedlam in Chinese markets earlier this week has helped send oil prices to their lowest point since 2009 (EnergyWire, Aug. 25).

West Texas Intermediate briefly nosed below $38.75 a barrel yesterday. The U.S. Energy Information Administration currently sees WTI averaging $49 this year and $54 next year.

That will continue to stress the economics for shale producers. Some oil bulls think the "rolling off" of the industry’s hedges might be the issue that finally forces E&Ps to cut production.

Hedging is a standard practice in the oil business, offering a kind of insurance for firms that know very well how moody crude prices can be. For example, a company can buy contracts for the year ahead to lock in a minimum price for some of its barrels.

But this year, the industry has relied on hedges it bought in 2014, when prices were much higher.

"U.S. E&Ps were ‘fortunate’ that for 2015 many of them had locked in volumes at prices that were more similar to 2014 levels," Praveen Narra, an analyst with Raymond James & Associates Inc., wrote this month. "We estimate that ~20% of the industry’s production was hedged at closer to 2014’s price levels of $90+."

As these hedges wear off, shale companies will become more exposed to current market prices.

Will credit dry up?

Another factor to watch for prices: This fall, shale firms will face their banks.

With oil prices still low, banks may finally shrink the lines of credit that are especially important for small and medium-sized shale shops.

Against low prices, no hedges and no way to raise money, a shale company might decide it’s time to reduce output.

Then again, the E&Ps have shown they’re full of surprises.

Larry of Frost & Sullivan said he’s now hearing that many producers are breaking even at $30 per barrel, and that some are breaking even at $20 per barrel.

Last fall, analysts were widely ballparking break-evens of $70 to $90 per barrel, or even more, according to a report from Reuters.