As U.S. oil production growth appears to be heavily weighted to the back half of 2017, how much cash producers can secure for those barrels will be a major factor in whether lofty production targets can be maintained into 2018. That’s where hedging comes in. Hedges on oil and gas production help E&Ps lock in pricing for their future volumes, taking out much of the price risk from selling into spot markets. However, activity has been light as of 2Q, and the lack of 2018 oil hedging leaves production vulnerable.
There are plenty of factors that drive producers to hedge. E&Ps have looked to insulate cash flow amid plans for rapid production growth like we’ve seen in the Permian and Northeast. High leverage is another factor driving hedging decisions, as operators look to protect their balance sheets from price swings and give greater certainty to creditors that interest payments can be met. Additionally, commitments with pipelines for takeaway capacity can drive hedging decisions, mainly for natural gas production.
2017 hedge books have largely been set in stone since 4Q16 after the announcement of OPEC-led production cuts spurred a price rally and rapid build-out of U.S. E&P hedge positions. With 44% of oil volumes hedged for the remainder of the year, short-term price swings aren’t likely to curb production activity in 2017. Looking ahead to 2018, however, it is valuable to look at how hedging has changed year-over-year.
The chart below shows the percentage of 2018 oil production that 20 independent E&Ps have hedged as of 2Q17 compared to 2017 oil hedges as of 2Q16. Some producers like Concho, PDC, and Encana have consistently hedged their oil production year-to-year. Numerous producers like Newfield, Pioneer, Noble, and Whiting have significantly smaller hedging positions for next year’s production.
With so much volume still unhedged, 2018 production targets are vulnerable. The 20-E&P sample showed that just 11% of consensus oil production is hedged for 2018 and a third of natural gas volumes. This is up from about 8% of oil and 25% of gas volumes as of 1Q. Relatively low hedging activity for 2018 isn’t a surprise, as spot pricing averaged $46.70/bbl, but producers are likely to increase their hedged volumes with oil prices now hovering around $50. The extent to which E&Ps lock in pricing on 2018 production throughout 3Q will be very important as the global conversation begins to shift from “How balanced are oil markets?” to “What effect will expiring OPEC production cuts have on any balance achieved to date?”
The chart below shows the comparison of hedged and unhedged oil production in 2018 for 20 independent E&Ps as of June 30. Almost 345 Mb/d of oil and 9.6 Bcf/d of natural gas are hedged in 2018, compared to more than 1,200 Mb/d and 14.5 Bcf/d for the remainder of 2017.
In our Oil Market Outlook, BTU Analytics forecasts that WTI prices will remain below $50/bbl into 2018, so producers’ opportunities to lock in 2018 volumes isn’t necessarily expected to improve the longer they wait. Conversely, as operators have highlighted capex flexibility and operating within cash flow in 2Q earnings calls, a lack of hedging activity may signal that they are willing to respond if prices fall. For a deep dive into our U.S. production forecast and a closer look at hedging, see the latest edition of our Upstream Outlook, published earlier today.