Surprise, Surprise!

Jim Brown
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A handful of shale drillers thought they were being really smart with the hedging plans but their moves proved to be really dumb. Now they are facing huge revenue declines and probably a sharp drop in their stock prices when Q4 earnings arrive.

When is a hedge not a hedge? When you think you are smarter than the market. At least six companies that hedged their oil prices did it with a "three way collar" rather than a straight hedge. Normally a company buys a put at say $85 and sells a call at $105 to offset the cost of the put. They can do this a variety of ways with options and futures but I am going to keep it simple here. In that example their profits are capped at $105 and they are protected with $85 as their low price. Many banks require oil hedges in order to loan companies money. However, analysts have found that at least six companies were adding an extra step of selling a lower put, say a $70 put to generate some extra premium. They never expected oil prices to go below $70 so that extra premium received offset the cost of their overall hedging program. Unfortunately that meant they were no longer hedged below $70. As long as oil prices stayed over $70 everything worked as planned. Under $70 and they are at risk. Their three-way collar only protected them for the $15 spread between $70 and $85. Everything under $70 is a loss of revenue.

This means the companies that used a straight hedging strategy are going to come out of this okay. Those that tried to game the system are going to lose a lot of money. This will force them to further cut back on drilling programs simply because they are hemorrhaging cash.

The companies that have been outed so far include Pioneer Natural Resources (PXD), Noble Energy (NBL), Anadarko (APC), Bonanza creek (BCEI), Carrizo Oil and Gas (CRZO), Parsley Energy (PE) and Callon Petroleum (CPE). Pioneer was called out as the biggest user of three-way collars and potentially exposed to large losses. Pioneer hedged 85% of 2015 production using a $99.36 upside cap and $87.98 floor. However, they sold another put that put in a subfloor at $73.54 so as long as oil is under $73.54 they are losing money. Basically they get the price of oil today plus the $14.44 difference between the top hedge points. Using Friday's close at $56.91 they would receive 71.35 per barrel instead of the $87.98 on the initial hedge position. That is a significant difference since they hedged 95,767 bpd for all of 2015. They will receive $1.86 million less revenue every day because of the three-way collar or $167 million per quarter. That is 14% of their revenue and a major hit.

Noble Energy hedged 33,000 bpd and will lose $50 million in Q1 at the current prices as a result of the hedge. Bonanza Creek hedged with a floor of $84.32 and a subfloor of $68.08. They will lose an extra $8 million in Q1. Callon hedged 158,000 bpd with an initial floor of $90 and subfloor of $75. That will cost them $3.3 million in additional losses.

Over the last two weeks the active rig count in North America has declined -89 rigs. That is a huge drop and the most since the recession. However, this is just the beginning. Statistics show that rigs don't decline until well after oil prices peak.

In the CNBC chart below it shows prices in red and rig counts in blue. Because rigs are contracted for months and even years in advance the real decline in activity does not occur until well after the price decline. Some analysts are talking about a drop of 40-50% in active rigs over the next 12 months if prices remain this low.

The active U.S. onshore rig count peaked at 1,929 back on October 31st and declined to 1,875 last week. Canada lost -40 rigs last week and Gulf of Mexico lost -2 to 58.

CNBC Chart

Is cheap gasoline really good for the economy? The short answer is yes. Gasoline demand was 9.373 million barrels per day last week compared to 9.016 bpd for the same week in 2013. That is 393.67 million gallons of gasoline per day. At the current national average that is $964.5 million a day in fuel spending, down from $1.496 billion a day in early June. That is a whopping $531 million per day in savings. That is a heck of a stimulus boost for the economy.

However, the oil and gas boom has added between $300-$400 billion a year to the U.S. economy for drilling, producing, transporting and refining oil. On one side the consumer has a few extra dollars in their pocket but a prolonged decline in oil prices is going to cut the impact of the activity in the energy sector by -25% or more.

Goldman Sachs looked at the cost basis for the top 400 new oil fields and found that less than a third are still profitable with oil at $70. With oil closing at $57 on Friday there are even more projects in the unprofitable column. If the unprofitable projects were halted it would shut down more than 7.25 mbpd by 2025. That equates to 8% of current production. In 2015 alone companies are making final investment decisions on 800 projects worth more than $500 billion. If prices remain around $70 more than $150 billion of those commitments won't be made. At $65 per barrel more than 50% of those projects will not be funded. These are projects that won't begin producing until 2020 or even 2025. Energy producers have to take a very long term view because of the upfront expense and the long lead times to complete.

More than 35% of the capex from S&P-500 companies today comes from energy companies. That compares to 10% ten years ago. In 2006 there was $300 billion in debt on the balance sheets of exploration companies. Thanks to nearly zero interest rates that has risen to nearly $3 trillion today. As much as $800 billion is subprime high yield debt that could be at risk if prices remain low.

I believe low gasoline prices are the bigger benefit because it is not just the U.S. but all over the world. History has shown us time and time again that low fuel prices stimulates growth and produces economic booms. When fuel is cheap people do more. Companies use the savings to expand and oil demand rises. This cycle has been repeated often since the 1950s.

Oil demand is about 92.0 mbpd and expected to rise to more than 93.0 bpd in 2015. If gasoline prices remain low we could see an even higher demand spike. People forget that annual depletion averages between 4.5% to 7.0% worldwide. Using an even 5% that means we lose roughly 4.6 mbpd every year to depletion as fields decline as the oil is removed.

That means every year we have to find, develop and produce 4.6 mbpd of new oil to replace the oil we are losing from depletion. If prices remain low, drilling activity will decline and depletion will overpower new production. This is a delicate balance between new production and old production and once that balance tips in favor of depletion prices will rise but it can take 5-7 years for drilling activity to resume and production increase.

We can have too much of a good thing today in low gasoline prices and then pay for that in the years to come if overall oil production dips below demand. Be careful what you wish for.

Oil Inventories

Crude oil inventories declined by -847,000 barrels to 379.9 million. This was less than the expectations for a -2.2 million barrel drop. Crude imports fell -564,000 bpd and refinery demand declined by 326,000 bpd. Imports should be light the next couple weeks because refiners are taxed on the oil in inventory on Dec-31st. The first two weeks of January are usually heavy import weeks as ships waiting offshore for the calendar to expire finally make landfall.

Gasoline inventories rose +5.3 million barrels to 222.0 million and a multi-month high. This is also a result of refiners trying to reduce oil in inventory by refining as much as possible. This was the sixth consecutive week of above average inventory gains. Gasoline demand rose by a whopping 824,000 bpd as cheap gas promoted more driving and retailers stocked up ahead of Christmas week when drivers will be on the road. Imports rose +212,000 bpd as well.

Distillate inventories declined -200,000 barrels to 121.5 million. Demand for distillates also surged by +774,000 bpd. This was probably heating oil demand, jet fuel stocking ahead of the holidays and that last minute surge of truck deliveries burning diesel.

Refinery utilization declined from the record 95.4% the prior week to a still strong 93.5%. Cushing inventories rose sharply from 24.9 million barrels to 27.8 million. This is related to the end of December tax bill as well.

U.S. production rose to another post 1983 record at 9.137 mbpd.

In the graphic below green represents a recent high and yellow a recent low.

Propane inventories declined by -.77 million barrels to 78.39 million. Demand rose slightly from 1.45 mbpd to 1.24 mbpd.

Natural gas inventories declined -64 Bcf to 3,295 bcf. Inventories are now -7.3% below the five year average at 3,563 Bcf and +0.2% above year ago levels at 3,289 Bcf. There were big declines in the last two weeks in 2013 and that offset the mild weather we have seen over the last couple weeks.

The blue line in the chart below shows the current inventory relative to the five year average.


The market exploded higher last week with the S&P flirting with record territory on Friday. I would expect some choppy markets this week because of mild profit taking from last week's gains. However, the bulls are still buying the dips and the futures are flat on Sunday night suggesting nobody is in a rush to sell.

Jim Brown

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