Oil companies that locked in part of their production at prices before the oil war between Russia and Saudi Arabia are in a better position to survive record low commodity prices, experts said.
Source: Houston Chronicle
Muscling for dominance and seeking to take market share from U.S. shale producers, Russia and Saudi Arabia have vowed to flood the global market with crude oil, sending prices down to the $32 per barrel.
However, oil companies that signed contracts to lock part of their production at $50 per barrel prices before the crash in an industry practice known as “hedging” will fare better than their peers who did not, said Jesse Lotay an energy attorney with the San Antonio office of the law firm Jackson Walker.
“The latest drop in oil and gas prices will stress test the energy industry,” Lotay said. “Against a backdrop of global oversupply, demand contraction, and geopolitical uncertainty, oil and gas companies will face unprecedented pressure to remain profitable.”
Hedging, he said, works by locking in part of a company’s production at current prices over the next few weeks or months. Oil companies typically use hedging to make part of their revenue more predictable while buyers use them to make their budgets more predictable.
In situations where commodity prices unexpectedly go down, oil companies make extra money on the price difference. In situations where oil prices unexpectedly go up, buyers save money on the price difference.
Banks and other investors often require oil companies to create a “hedge book,” Lotay said. Oil companies that set up hedging contracts for part of their production before the Russian-Saudi oil war price crash, he said, are now receiving at least $20 per barrel more than their peers who did not lock in part of their production.
“The ability to establish, in advance, a minimum price that an oil and gas company will receive for its production gives it the advantage of financial certainty that allows it to ensure for drilling operations, debt-service, and future growth, asset acquisitions, and exploration and production activities,” Lotay said.
The Russian-Saudi oil war came at a time when many oil companies were facing a credit crunch from investors skeptical after a decade of losses.
It remains to be seen if oil companies will lock in part of their production at $30 per barrel to protect themselves if prices fall into the $20 per barrel range. Nonetheless, hedge books are seen as a way for oil companies to reduce financial risk, said Mark Sadeghian, with the New York credit rating agency the Fitch Group.
“During a price crash, a large hedge book is a good thing,” Sadeghian said. “ On a mark to market basis, it’s in the money. It’s a liquid asset and can be monetized. You typically have high quality counterparties. There’s a lot of positives of having a hedge book. The rest of the cycle, it may cap your upside but is high value in a downturn.”
