Oil prices ended 2017 on a high note, closing above $60 a barrel, which was the best level in more than two years. However, most oil producers don't expect that to stick around. That's evident by the fact that they've hedged more than 60% of their production this year to protect against a decline. That's the highest level of hedging in years, according to a report by analysts at RBC Capital Markets.
That said, those oil hedges work both ways. While it will help protect these producers from another drop in crude prices, it also caps their upside, since many use hedges that trade the profit potential above a certain level in exchange for some downside protection. As a result, oil stocks that don't have any hedges in place would be big winners if crude keeps rising while those with significant volumes hedged would lose out on that upside potential. Here's a closer look at the potential winners and losers if oil has a big year in 2018.
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Taking a bold stance on oil
While most oil producers in the U.S. have hedges in place for 2018, EOG Resources (NYSE: EOG), Anadarko Petroleum (NYSE: APC), and Centennial Resource Development (NASDAQ: CDEV) currently don't have any for oil this year. So if crude keeps heading higher, these oil companies would capture all of that improvement.
One of the reasons EOG doesn't hedge any oil right now is that it is one of the lowest-cost shale drillers in the industry. In fact, at $40 oil, the wells it drills can earn a 30% after-tax return, while for many others would be unprofitable to drill. Those lucrative returns enable the company to generate enough cash when crude is at $50 a barrel to deliver double-digit oil production growth.
Anadarko Petroleum similarly didn't have any oil hedges for 2018 at the end of the third quarter. That's a shift for the company, which had two sets of hedges in place for 2017. While those hedges helped protect cash flow when crude dipped earlier in the year, they began costing the company money as it recovered. Here's how much those hedges cost it each day given where oil prices were at the end of the year:
As that table shows, Anadarko was missing out on more than $200,000 per day in revenue from its oil hedges at the end of last year. Multiply that over a year, and it's $75 million in lost cash flow. However, with none in place for this year, the company anticipated that it would generate enough cash to finance its capital expenditure plan with more than $700 million to spare, and that's when Brent was around $61 while WTI was near $55. If crude prices keep rising from their currently higher levels, Anadarko will generate significantly more free cash flow this year.
Finally, Centennial Resource Development is unabashedly bullish on oil prices, which is why the company doesn't hedge any oil production. Fueling that confidence is the belief that analysts are way too optimistic about the ability of shale drillers to grow production, which the company sees coming in below expectations and causing crude prices to keep running higher in 2018. That's why Centennial is drilling as fast as it can, with plans to grow oil production by a jaw-dropping 71% compound annual growth rate through 2019 so it can capture the upside it sees in crude prices.
Potentially paying a high price for cautiousness
That said, while this trio is bullish on oil prices, many peers remain cautious after having watched oil prices bounce around quite a bit in recent years. They've put hedges in place to protect their downside, at the risk of giving up the upside past a certain point.
Leading the way is Parsley Energy (NYSE: PE), which has hedged 100% of its estimated output for 2018. For comparison's stake, the company with the next highest level is around 60%. On the one hand, more than half of Parsley's hedges have no cap while those that do have a ceiling that's much higher than the current price. For example, those in the first quarter top out at $68.85 per barrel, while those in the fourth quarter give it upside up to $75.65 a barrel. So while crude would have to rally sharply before Parsley would regret capping its upside, it would still lose out if that happened.
Another company with significant volumes hedged for 2018 is Concho Resources (NYSE: CXO), which has about 63% of its expected oil output hedged next year. However, unlike Parsley Energy's hedges, which have no ceiling or one well above current prices, Concho uses contracts that lock in a specific oil price, which is currently around $51 a barrel. While that decision paid off when crude crashed last year, it's backfiring now that oil has rebounded, since only about 37% of the company's output can capture that upside.
Hedges can both help and hurt
Hedging helps producers mute some of the volatility of oil prices. However, that insurance isn't free, with it often costing them their upside potential. That's why investors who are bullish on oil should make sure that hedges won't hold back their oil stock's ability to profit if oil prices keep rallying in 2018.
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