3 Ways Oil Companies Can Protect Themselves Against Falling Prices

Image source: LINN Energy LLC.

Crude oil has been on a roller-coaster ride in 2015. After bottoming out this spring in the low-$40-per-barrel range, crude oil finally started to rebound in May, hitting a high of more than $60 per barrel. That rally has started to fade in recent weeks as the price of crude has fallen back, and is now more than 20% from its recent peak, entering bear-market territory once again.

In light of this weakness, we asked our energy writers what oil companies can be doing to protect themselves against falling prices. Here's what they think.

Jason Hall: The easiest way oil companies can protect themselves against the damage of falling oil prices is by cutting production. I know it may sound counterintuitive, because cutting production in a falling-oil-price environment would only further reduce revenues, but if the price is falling due to oversupply, production cuts can help restore supply and demand balance, eventually leading to increasing prices. Of course, this only works if the entire industry is cutting production to restore trade balance, and that clearly hasn't happened, as oil prices essentially have been falling for more than a year.

However, U.S.-based oil producers can gain another benefit by cutting production -- lowered capital spending. The American shale boom has been driven by high-cost well development techniques that require regular drilling of new wells just to maintain current production levels.

If a company cuts production by reducing capital spending on new wells, this can seriously lower costs. If the balance sheet is strong enough, and a company's cash flows from its existing wells can cover expenses, many producers may be able to just ride out the downturn, and then crank production back up once trade balance re-establishes and oil prices start to go up.

For this to work, the company must have a strong balance sheet, low operating costs and debt, or the risk of declining production -- and cash flow -- may not be an option.

: The best way for an oil company to protect itself from falling oil prices is to hedge production in the futures market. Oil companies have a number of options at their disposal providing them the opportunity to be very conservative to fully mitigate the impact of oil's price for several years -- or they can choose just to mute some of the impact of oil-price volatility.

I'm going to use upstream MLPLINN Energy as an example, because it has one of the strongest and most diverse hedge books in the oil industry, as roughly 90% of its production is hedged for 2015. We can see this on the following slide:

Source: LINN Energy LLC Investor Presentation.

As that slide notes, LINN Energy has hedged 90% of its oil production this year, with about 80% of that hedged via swaps. Swaps lock in production at a set price, or in LINN's case, $86.93 per barrel. This means that no matter what the oil price does through the end of the year, LINN Energy is guaranteed to receive that price for the 80% of its production it hedged via swaps. While swaps don't cost an oil company anything, they do eliminate the upside to higher oil prices.

Another conservative strategy that LINN also uses is to write puts against its production. Just like in the option market for stocks, puts guarantee a minimum sales prices -- for LINN Energy it's $90 per barrel for the 17% of its production that's hedged -- while maintaining upside above that price. Put another way, with oil well below $90, that's the lowest price it would receive; meanwhile, it has unlimited upside should oil rocket above $90. The problem with puts is that they cost money, so it's an expensive insurance for an oil company.

A final strategy that LINN uses, and which is much more common among many shale drillers, is three-way collars, sometimes known as costless collars. These help mute the downside at the cost of limiting the upside past a certain point.

LINN Energy currently has $70 by $90 by $102 collars for some of its production this year. What this does is cap the upside at $102 per barrel, while cushioning the downside -- in this case, by $20 per barrel, or $90 minus $70. In other words, at the current oil price of around $45 per barrel, LINN is actually able to realize $65 per barrel on oil hedged via three-way collars.

As we can see from this example, oil companies have a variety of hedging techniques at their disposal to protect against falling oil prices. Companies can be very conservative and hedge all of their production with swaps or puts several years out, or use costless collars on a small portion of their production to mute the downside.

Dan Caplinger: As Jason and Matt discuss, oil companies can protect themselves from falling prices by hedging, or by reducing production temporarily in order to help support the market. Yet the more fundamental question is whether energy producersshouldtake measures to reduce their risk from crude oil and other energy prices, or whether they should have transparent and predictable exposure to energy prices, and let shareholders make their own decisions about whether to bear that risk.

History shows that companies often make bad decisions about hedging. For instance, in the mining industry, many major gold producers missed much of the decade-long rise in gold bullion because they had hedged their forward production, locking in prices that turned out to be far lower than the prevailing market price. Many miners ended up reversing their hedges at much higher prices, costing them millions in lost profits, and giving them exposure to precious metals just as they were rising toward peak levels.

For investors, the simpler way to handle protection from oil prices is for companies not even to try. Instead, let investors hedge their bets on their own if they're so inclined, leaving the companies to remain fully invested in the prospects of the oil market going forward.

The article 3 Ways Oil Companies Can Protect Themselves Against Falling Prices originally appeared on Fool.com.

Dan Caplinger andJason Hall have no position in any stocks mentioned. Matt DiLallo owns shares of Linn Energy, LLC. 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.

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