Analysis: Hedging data illustrates risks taken by North American oil producers

A handful of North American oil companies were happy to take on significantly more risk in 2019 in their pricing strategy per barrel – and would have suffered greatly in the price drop of early 2020.

The latest hedging data from Evaluate Energy illustrates that producers were using more three-way collars by the end of 2019 than in years prior, relative to other derivative arrangements such as standard two-way collars or fixed swaps.

Source: Evaluate Energy Hedging Database

This meant that while these North American producers would be protected during more stable pricing periods, a period of steep pricing cuts would leave them exposed to a far greater extent.

Importantly, however, the data shows that the move to three-way collars was not an industry-wide trend, with only a small number of producers taking on this extra risk.

“According to data available in Q4 2019 company reports, North American producers headed into Q2 2020 with over 100,000 bbl/d of oil hedged under three-way collars,” said Isabelle Li, Senior Analyst at Evaluate Energy.

“While this is more than double the volume hedged under three-way collars at the same time two years ago for the equivalent period, the surge in volumes is mainly caused by a small group of companies that were already using three-way collars before. These companies were therefore already happy with higher risk involved compared to swaps or standard collars, and over the years they increased their usage of this derivative. Standard collars were often replaced by three-way collars by these few producers.”

Source: Evaluate Energy Hedging Database

Evaluate Energy data shows that only seven more companies hedged using three-way collars heading into Q2 2020 than did heading into Q2 2018; a total of 28 companies from the 116 that hedged oil for the upcoming second quarter.

2019 represented a greater level of oil pricing stability at higher rates than upstream companies had seen in recent years.

“In times of oil price stability, a three-way collar represents an attractive, cheaper option for oil producers,” added Li. “Unlike more expensive standard collar arrangements, which operate between a ceiling price and a floor price, a three-way collar brings in an extra short-put component to the equation, introducing a ‘sub-floor’ price. The increased risk in a three-way collar is that if the commodity price benchmark in question falls below this ‘sub-floor’ after already passing the floor price, the producer is no longer protected by the floor as with a standard collar.”

“While volumes increased under three-way collar arrangements at the end of 2019 for Q2 2020 and beyond and prices indeed stabilized over time, our data shows that most companies decided that the cost reductions through entering three-way collars was not worth the risk. This will have saved many oil hedgers further turmoil in the recent price plunge in early 2020.”

For more on Evaluate Energy’s hedging database, click here.

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