Oil Stocks: Dont Overlook This Important Announcement From Pioneer Natural Resources

By Markets Fool.com

Continue Reading Below

Photo credit: Courtesy of Pioneer Natural Resources, Sands Weems-Photographer.

Last night,Pioneer Natural Resources issued two important press releases, updating investors on its operations. One release detailed the weather problems that were impacting the company's drilling operations in West Texas, while the other noted changes made to Pioneer's hedge book. Investors will want to pay particular attention to that second release.

The collars that were strangling Pioneer
Some background information is required to understand the importance of the second release. When Pioneer Natural Resources reported its third-quarter results, the company boasted that 85% of its oil production was hedged through the balance of 2014 and all of 2015. That appeared to be one of the strongest hedge books in the oil industry. However, the hedge book came with what proved to be one fatal flaw: it was mostly composed of three-way collars. This hedge type generally worksgreat, but when oil prices drop significantly it does not work as well as intended.

The example below from a Pioneer Natural Resources investor presentation shows that as long as the price of oil remained above $75 per barrel, the company would realize $90 per barrel while having upside all of the way to $135 per barrel should the price of oil rise.

Continue Reading Below

Source: Pioneer Natural Resources Investor Presentation.

Unfortunately, when oil prices unexpectedly plunge, that $90 floor begins to erode. The plummeting price of petroleum in recent months, now below $50 per barrel,has the company realizing much less than the $90 per barrel it was expecting as its floor.

The following chart shows thatthe more oil prices moved south, the lower it pushed the company's average realized price after accounting forits other hedges and its unhedged volumes.

Chart by author.

With oil now below $50 per barrel, Pioneer's average realized oil price has slipped all the way to the high $60s. That is wiping out a chunk of the company's cash flow, which it has been relying on to fund growth.

Fixing the problem
The company is taking action to protect its cash flow by converting all of its three-way collars into fixed price swaps. The switch puts a solid floor below85% of the company's production, with an average price of $71.18 per barrel. This protects Pioneer in case oil prices keep sliding and stay at much lower prices for the full year.

Pioneer CEO Scott Sheffield addressed the matter in the press release:

Over the past five years, our derivative strategy has successfully protected our cash flow and allowed us to execute a highly productive drilling program. In light of the weak oil price environment forecasted for 2015, we elected to convert mostof our 2015 oil derivatives from three-way collars to fixed-price swaps to establish a firm oil price floor and lock in the corresponding cash flow. Pioneer's adjusted derivative portfolio, combined with our exceptional assets and strong balance sheet, positions the Company to manage through the current price downturn and emerge as an even stronger company when oil prices recover.

This is a prudent move given the uncertainty in the market, in whichno one knows where or when oil prices will bottom nor how long prices will stay low.

Investor takeaway
By locking in a cash flow floor for most of its production, Pioneer Natural Resources can operate confidently in this uncertain environment. While the change has eliminated much of its cash flow upside this year, the company retains that upside for 2016 and beyond as it hasn't scrapped next year's three-way collars just yet. Overall, the company is taking prudent steps to reduce risk in 2015.

The article Oil Stocks: Dont Overlook This Important Announcement From Pioneer Natural Resources originally appeared on Fool.com.

Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.