Oil Hedges Won’t Be Enough

Summary

  • Russian and Saudi oil price war will crush oil stocks again.
  • Here’s a quick examination of the hedging several oil companies have and the implications for each.
  • I am not buying any oil stocks on crash as secular headwinds are overwhelming.
  • Investors should still be looking to exit oil stocks opportunistically if possible.

Russia and Saudi Arabia got into a spat Friday that turned into an oil price war. Oil prices are plunging in futures markets below $30 per barrel. 

While the oil stocks we own are the best of the patch, but that’s not saying much. It’s hard to sell when there is blood in the streets, but that is what I plan to do. 

Russian Roulette

Nobody knows for sure what probable richest man in the world, election messer wither, murderous oligarch, skim king Vlad Putin, has up his sleeve with oil, but here is my thought process. 

Not agreeing to a production cut with OPEC backed Saudi Arabia into a corner. Saudi Arabia had only two choices: once again shoulder the burden of oil cuts themselves or decide to go the complete opposite direction and “drill, baby, drill.” 

Prince Mohammed Bin Salman, presumptive ruler of Saudi Arabia, not one to take to being pushed around, has chosen to raise oil output. He has essentially green lighted OPEC members to flood the market with oil. 

What’s in that for Russia? Well, about the same thing that is in it for all of OPEC. An outright assault on U.S. oil, shale in particular. 

Burying Shale Again 

There is around $200 billion of high yield debt tied to shale stocks. Sending the price of oil careening lower is going to impact much of that debt. There will be bankruptcies from this. Several will happen quickly. 

Hedges on oil production will protect some companies, but not completely. Few oil companies are completely hedged because they always want some upside in the event of a price surge.

Come April, many oil companies have their loans and debt facilities evaluated by the banks that lend to them. Given the pressure that banks already face from concerned shareholders and the divestiture movement, I do not expect there to be much generosity. 

With banks unlikely to come to the rescue again, we should expect several oil companies to declare bankruptcy by summer. 

The Next Shale Resurrection

Private equity and management will then come in to take over from destroyed shareholders. 

Why would management and private equity buy the corpses, sometimes warmed over from a previous bankruptcy, of the oil industry? It comes down to conventional production and rational expectations of future unconventional production. 

Companies with conventional production have ongoing revenue streams that cost little to support. Fracking is going to come under increasing EPA pressure at some point, whether 2021 or later, and companies have to factor that in. 

The companies with the best profiles for riding out the end of the oil age over the next two decades will get a bid. That bid will not be terribly high though. Expect vulture pricing. The management and PE firms will then control production to maximize profits and line their pocketbooks. 

What that means to oil stock investors is that there is likely no coming back from this for many oil stocks. The SPDR Oil And Gas E&P ETF (XOP) has already been on the slide to oblivion. It is there now. And will likely sink further in, with little hope of rising again. Holders of XOP should sell, take their losses and remember this old Wall Street adage: “you don’t have to make your money back where you lost it.”

Oil Hedges Among Permian Focused Oil Companies

As you know, I believe that Chevron (CVX) and Exxon (XOM) especially are doomed to massive shrinkage and possible breaking up. So, I don’t really even care what their plans are. They are both value traps as I’ll write about separately. 

The only companies in the oil patch that I am interested in are those with a Permian focus or at least major Permian operations. Those companies, especially those with some conventional cash flows and pending new natural gas revenues due to new pipelines, have a chance to thrive as U.S. oil production ebbs, intermediate term demand settles onto the “peak oil plateau” and the potential for Middle East conflict exists.

Briefly, here are the hedging positions (generally found in company presentations on their websites) of five companies that some of us have small positions in: 

  • Devon Energy (DVN) – has about 40% of oil production hedged at $53 per barrel, leaving about 60% exposed to crashing oil prices. Devon’s break even is $46.50 per barrel. Oil crash could dent share buyback program.
  • Occidental Petroleum (OXY) – set up hedges to be able to pay dividend in 2020 with oil at $40 per barrel. They are essentially not hedged in 2021 and need an oil price rebound to avoid the fire sale Carl Ichan warned about.
  • Ovintiv (OVV) – 70% hedged in 2020 at $52/bbl. They do own short puts at $43.44/bbl offsetting long puts at $53.44, meaning they are making $10 on that spread, but will have to either buy oil or make up the price difference below $43.44 if there is one later. One of the better hedge books relatively speaking. 
  • Parsley Energy (PE) – most production is hedged with break even near $40 for 2020, though they are not hedged for 2021 yet. 
  • Pioneer Resources (PXD) – has approximately 50% of 2020 volumes hedged with break even in the low $40s per barrel. 

What you can see with the hedging positions of these companies, which are among the best hedged, is that they are only hedged to break even prices in the lower $40s per barrel. What if oil stays in the $30s per barrel through summer of 2021? 

It is very possible that there isn’t a single profitable oil company this year.

Oil Investing Approach

For companies that stay in business, which I believe all of those above will, the outlook is still murky at best. Unless oil prices rise significantly, most oil companies will see ongoing major debt obstacles. Occidental is clearly on that list of at risk for a debt crisis. 

About the only thing that is likely to push oil prices up soon, would be a conflict in the Middle East. As you probably know, I am on record as saying that a conflict involving Saudi Arabia and Iran during the Trump administration was likely. Well, that means it either happens soon or I was wrong. I still put the odds at better that 50/50 that a conflict happens by autumn, but it is no sure thing. 

Because I have years of experience in oil related investing, I am likely to take a stab at speculating on an oil recovery at some point. I will trade oil however, not oil stocks. I have been following ForexAnalytix for 3 years now. They do a regular morning webinar that is outstanding. I have appeared on it a few times to boot. 

ForexAnalytix research has been spot on and I am likely to look for an entry in line with their trading approach. But, that is what it is, trading. Oil investing is dead. 

A few last thoughts on oil investing. I covered “why oil stocks are priced for Armageddon” almost a year ago. All those reasons still hold. And now, we have a Russian inspired oil price war.

Oil is a very manipulated market. Oil executives have been irresponsible in the U.S. The divestiture movement is successful. It’s a very hard market to navigate without a supernatural compass. 

There is an old Wall Street saying: “you don’t have to make your money back where you lost it.” For most people who want a less speculative approach, I would head that advice. I think most folks are better off and will experience less volatility investing in the “smart everything world.” 

Disclosure: I am/we are long OVV, OXY, PE, PXD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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