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Macro Hedge Decisions for Producers

July 16, 2014

Question from client:

We want to remove some of the risk from our portfolio. Is this a good time to add hedges for Crude Oil, Natural Gas, and Natural Gas Liquids?

 

R^2 Response:

1) Crude Oil

  • The Iraqi geopolitical situation is a wild card. But risk premium due to potential loss of production is getting built into the price.
  • Larger scale risks are being ignored. The US Dollar is poised to go much higher based on a relatively stronger US economy vs that of Europe and Asia. Demand destruction and US Shale production are negative fundamentals that will appear when transient geopolitical issues cyclically recede.
  • The US stock market is priced for perfection. It also should be a tell that more aggressive oil hedging is needed to lock in the favorable conditions that exist.
  • Backwardation is being cited as the reason why producers are underhedged. But there is a reason why oil is priced one way in 2014 and another way in 2016- lack of ability to export Light crude. Until the export ban is lifted and speculation is curtailed, the market will remain Backwardated.
  • Oil Basis risk must be respected here in the US. As production increases, infrastructure lags behind and catches up in staircase fashion. This adds volatility to locational pricing; managing the cash flows from this risk makes it more important to reduce this exposure.

 

2) Natural Gas

  • Pricing has put in a major bottom. Despite increased production (driven by the Marcellus); long term fundamentals are supportive of prices. Whereas oil is losing demand from higher prices, gas is gaining demand from the power stack, industrial use, commercial trucking, and future LNG exports.
  • Costless collars are very favorable for producers.

 

3) Natural Gas Liquids

  • NGL pricing is still challenged by robust shale rich gas production. Demand responses are occurring, but the stepwise lag is keeping supplies healthy.
  • Ethane can be hedged with natural gas. But direct ethane hedges may still be warranted given the possibility of reaching the limits of ethane rejection.
  • Propane in Cal 15 is ~48% of Crude Oil. Given a very healthy oil price, C3 can certainly be hedged directly.
  • Heavies (C4 and C5) can be hedged with C3 or oil proxies. Proxy hedges require company-specific inputs to determine suitability, as well as other considerations.



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