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Producers' attempts to hedge against falling prices are falling victim to the oil market's volatility
Trying to guess whether oil prices, which jumped by as much as 25%, to $130, on Sept. 22, will surge or slump? Don't look to the commodity producers for answers. Even companies pumping oil out of the ground don't have a clue where prices are headed. In this volatile market, several industry players have made ill-timed bets that have wiped out their profits.
Consider what happened this summer. Energy prices were skyrocketing and some oil and natural gas producers decided the rally wouldn't persist. To protect themselves against the downside, companies bought options and other financial instruments in an attempt to lock in high prices, a common practice known as hedging. In the most basic strategy, a producer makes an agreement to sell a commodity at a predetermined price at a later date.
But instead of falling, oil jumped from $120 to more than $145 in a matter of weeks, with natural gas and other resources spiking as well. Accounting rules require companies to report the difference between the current prices and the prices on their hedges. For example, if a company has a deal at $120 and the actual price of oil hits $145, it has to record a loss of $25.
That's essentially what happened to Chesapeake Energy (CHK), Newfield Exploration (NFX), Noble Energy (NBL), Range Resources (RRC), and others in the latest quarter. As energy prices reached new heights, the companies' core businesses pumped out healthy profits. But those earnings evaporated as a result of their trading operations. "A lot of people got creamed," says industry analyst Stephen Schork.
Energy producers are quick to note that such losses exist only on paper. Companies typically make deals that require them to deliver the commodities months or years down the road. The accounting rules, though, mandate that companies must value those hedges as if they had to hand over the goods now at the current price. Depending on which way prices move, losses one quarter can turn into gains the next. Stephen Campbell, vice-president for investor relations at Newfield, says that its portfolio of hedges, which took a hit in the previous period, was up slightly as of Sept. 23, when prices hovered around $107. Chesapeake's positions, down $6.5 billion last quarter, are now off about $6 billion. Range said their hedges were up in July. Noble could not be reached for comment.
Besides the earnings impact, there's also the worry that some producers aren't merely hedging but also speculating—that is, trading for profit rather than protection. Among the biggest concerns: short positions. In those trades, companies borrow money to wager that prices will fall. But if prices head in the other direction, lenders may ask for more collateral, forcing companies to come up with cash in what's known as a margin call. Even companies with lots of valuable oil or gas to sell may not be able to pump it out of the ground fast enough to meet those demands.
The results can be fatal. Earlier this year privately held SemGroup, which stores and transports oil and natural gas, made a big bet that energy prices would fall. As prices continued to surge, lenders asked the company to cough up more than $2 billion for a margin call. Unable to do so, SemGroup filed for bankruptcy in July, right around the time oil hit a peak of $147. Says Ed Hirs, the chief financial officer of DJ Resources, a Houston oil and gas company that doesn't employ these kind of strategies: "If prices remain high, we will see some [more] failures."