Year to date hedging losses and gains

Why management matters

It is tautological to say that management of oil and gas producers have no control over the price of the commodity they sell, which is subject to world market forces. It is inaccurate to say they have “no control” I suppose, since they can use commodity markets to “hedge” the prices they receive and tell shareholders they benefit from the “reduced volatility” that “hedges” can provide. Why should I give a shit about “volatility” if the way to avoid volatility is to lose millions of dollars in foolish “hedging” which is essentially gambling?

It is worth looking at the stellar reports in 2022 of some key oil & gas companies and comparing their results excluding “hedges” with what they actually reported. If the “hedges” have any value, that value should show up in earnings sooner or later. Shareholders can either benefit or be punished for management’s decisions. Where managers are petroleum engineers, geologists, and practical leaders, the result is usually relatively low costs compared to peers and excellent drilling and production results. Where managers venture into commodity price speculation investors are typically punished by the stupidity of their decisions. “Hedging” has become a disease that has addicted too many senior financial executives at Canadian energy companies and their counterparts in their banking syndicates who view them less as clients and more as prey.

Investors don’t blame management for poor results caused by low commodity prices. But it is fair to blame them for sub-par results in strong commodity markets where their relative performance is uniquely the results of their own decisions and judgment or lack of it. Year to date summaries of hedge book gains and (losses) and reported net income year to date June 30, 2022 tell the story.

A total of fourteen companies enjoyed profits totaling almost CAD$18 billion in the first half of 2022 and were burdened with total hedge book losses of only 3% of their net income.

Ten other companies that I follow had profits totaling CAD$5.6 billion in the first half of 2022, after booking losses totaling CAD$7.1 billion on their hedge books. Investors should consider removing and replacing directors from these companies. While Cenovus is in this group owing to its Q1 hedging losses, it is distinquished in that management took immediate action to close out the losing hedges and move on, reducing Q2 hedge losses to only CAD$53 million.

The rest of the poorly performing group got what they deserved - a bloody nose. CEO’s who stand before shareholders defending their practice of hedging a vow to keep doing it don’t deserve to keep their jobs. I find it interesting that four of the companies in this review - Birchcliff, Canadian Natural Resources, Tourmaline, Advantage Energy, Spartan Delta, Peyto and ARC Resources are neighbours in the Deep Basin and Montney plays and faced precisely the same risks and opportunities. But Birchcliff, CNQ, Tourmaline, Advantage, and Spartan Delta managed those risks and opportunities while Peyto and ARC took a bath on their hedges and their CEO’s and CFO’s keep defending the practice.

Birchcliff, did not hedge except to enter into basis contracts that act as a proxy for transportation to Henry Hub, and Birchcliff booked solid gains on those contracts during the first half of 2022. Canadian Natural Resources and Suncor eschewed the hedging disease altogether and Tourmaline kept its hedge book at very modest levels. Cenovus nad MEG suffered some losses on hedges and decisively abandoned hedges entirely when they saw those trades sinking under water, and enjoyed stellar results by gaining the full benefit of higher commodity prices thereafter. MEG actually booked a small gain on its residual hedges. These five companies benefited from managers who took action to deal with the commodity cycle and their shareholders were beneficiaries of their stewardship. They are cornerstone holdings in my energy portfolio. It seems that common sense is not common.

A brief look at ARC Resources “hedging” activities demonstrates the insanity of the management decision-making process. The table below sets out the potential benefits of the “hedges” if natural gas prices had fallen to $1.00 per million BTU at AECO; US$1.50 per million BTU at Henry Hub; and if oil and condensate prices had fallen to CAD$20 a barrel, with some sensitivity to prices a bit higher but still low enough there was a “hedging” benefit. In a nutshell, the “hedges” ARC had in place would have improved their results by a maximum of $688 million had commodity prices collapsed and remained at the lowest levels shown for the entire year. At CAD$30 a barrel for oil and fifty cents higher natural gas prices the benefit falls to $524 million; at $40 oil and another 50 cents on the gas price, the benefit would have been $167 million; and, at CAD$50 oil and CAD$2.50 natural gas there would have been no benefit whatsoever. Prices in fact have been over $100 for oil and over $6 for natural gas, and the cost of the “hedges” at those prices will total $1.768 billion if the prices do not fall.

(Note that only $1 billion of ARC’s hedge book losses have been booked year to date - the hedges remain under water and the estimated losses are based on $100 oil and $6 gas persisting until the hedges roll off)

For the ARC hedgebook to provide a measurable benefit, the world needed a catastrophic collapse of both its economy and energy prices. In that circumstance, the “benefit” of the ARC hedge book would be a rounding error in a sea of losses. There has not been a year in the past five where oil prices have languished at $20 a barrel for an entire year, just one very short period of price collapse at the outbreak of COVID.

There was an extended period where natural gas prices of $1.00 to $2.00 a gigajoule were common, but note that the total potential benefit of the natural gas “hedges” was no higher than $200 million in that extreme case, immaterial to ARC’s economics. But the cost of ARC’s natural gas hedges was a staggering CAD$768 million at the prices shown. With only about one third of ARC’s production hedged, the hedges were never going to do much to protect ARC’s balance sheet since if the prices did collapse most of the company’s production would be sold at a loss in any event. ARC’s natural gas hedges were the triumph of fear over common sense.

Well-managed companies got it right. Capable managers don’t gamble on commodities but do their homework, avoiding needless “bets” on future commodity prices or taking positions that are grounded in sound macroeconomic analysis. The best performing company, Birchcliff, not only abandoned hedges but committed to total elimination of its debt which the company says will happen by year end. Following that event, Birchcliff intends to pay a dividend (subject to board approval) of at least $0.80 per share in 2023 and thereafter. That makes BIR.TO a major part of my portfolio. Spartan Delta has made it clear it will not add hedges (most of which came with an acquisition) and will become debt free by year end 2023, following Birchcliff’s lead. Together BIR.TO and SDE.TO make up over half of my portfolio. I back good managers, not loose cannons.