Oil Crash Exposes New Risks for U.S. Shale Drillers

Photographer: Andrew Burton/Getty Images

U.S. shale oil production.

Tumbling oil prices have exposed a weakness in the insurance that some U.S. shale drillers bought to protect themselves against a crash.

At least six companies, including Pioneer Natural Resources Co. (PXD) and Noble Energy Inc. (NBL), used a strategy known as a three-way collar that doesn’t guarantee a minimum price if crude falls below a certain level, according to company filings. While three-ways can be cheaper than other hedges, they can leave drillers exposed to steep declines.

“Producers are inherently bullish,” said Mike Corley, the founder of Mercatus Energy Advisors, a Houston-based firm that advises companies on hedging strategies. “It’s just the nature of the business. You’re not going to go drill holes in the ground if you think prices are going down.”

Oil Prices

The three-way hedges risk exacerbating a cash squeeze for companies trying to cope with the biggest plunge in oil prices this decade. West Texas Intermediate crude, the U.S. benchmark, dropped about 50 percent since June amid a worldwide glut. The Organization of Petroleum Exporting Countries decided Nov. 27 to hold production steady as the 12-member group competes for market share against U.S. shale drillers that have pushed domestic output to the highest since at least 1983.

WTI for January delivery rose $2.41, or 4.5 percent, to settle at $56.52 a barrel today on the New York Mercantile Exchange.

Debt Price

Shares of oil companies are also dropping, with a 49 percent decline in the 76-member Bloomberg Intelligence North America E&P Valuation Peers index from this year’s peak in June. The drilling had been driven by high oil prices and low-cost financing. Companies spent $1.30 for every dollar earned selling oil and gas in the third quarter, according to data compiled by Bloomberg on 56 of the U.S.-listed companies in the E&P index.

Financing costs are now rising as prices sink. The average borrowing cost for energy companies in the U.S. high-yield debt market has almost doubled to 10.43 percent from an all-time low of 5.68 percent in June, Bank of America Merrill Lynch data show.

Locking in a minimum price for crude reassures investors that companies will have the cash to keep expanding and lenders that debt can be repaid. While several companies such as Anadarko Petroleum Corp. (APC), Bonanza Creek (BCEI) Energy Inc., Callon Petroleum Co., Carrizo Oil & Gas Inc. and Parsley Energy Inc., use three-way collars, Pioneer uses more than its competitors, company records show.

‘Best Hedges’

Scott Sheffield, Pioneer’s chairman and chief executive officer, said during a Nov. 5 earnings call that his company has “probably the best hedges in place among the industry.” Having pumped 89,000 barrels a day in the third quarter, Pioneer is one of the biggest oil producers in U.S. shale.

Pioneer used three-ways to cover 85 percent of its projected 2015 output, the company’sDecember investor presentation shows. The strategy capped the upside price at $99.36 a barrel and guaranteed a minimum, or floor, of $87.98. By themselves, those positions would ensure almost $34 a barrel more than yesterday’s price.

However, Pioneer added a third element by selling a put option, sometimes called a subfloor, at $73.54. That gives the buyer the right to sell oil at that price by a specific date.

Below that threshold, Pioneer is no longer entitled to the floor of $87.98, only the difference between the floor and the subfloor, or $14.44 on top of the market price. So at yesterday’s price of $54.11, Pioneer would realize $68.55 a barrel.

‘Better Upside’

David Leaverton, a spokesman for Irving, Texas-based Pioneer, declined to comment on the company’s hedging strategy. The company said in its December investor presentation that “three-way collars protect downside while providing better upside exposure than traditional collars or swaps.”

The company hedged 95,767 barrels a day next year using the three-ways. If yesterday’s prices persist through the first quarter, Pioneer would realize $1.86 million less every day than it would have using the collar with the floor of $87.98. That would add up to more than $167 million in the first quarter, equal to about 14 percent of Pioneer’s third-quarter revenue.

Exposure Cost

The strategy ensures that the bulk of Pioneer’s production will earn more than yesterday’s market price. The three-ways will also prove valuable if oil rises above the subfloor.

“What they have is much better than nothing,” said Tim Revzan, an analyst with Sterne Agee Group Inc. in New York. “But they left some money on the table that they could have locked in at a better price.”

Noble Energy used three-ways to hedge 33,000 barrels a day, according to third-quarter SEC filings. Assuming yesterday’s prices persist, Houston-based Noble will bring in $50 million less in the first quarter than it would have by locking in the floor prices.

Bonanza Creek, based in Denver, Colorado, set up three-ways with a floor of $84.32 and a subfloor of $68.08, SEC records show. If prices stay where they are, the company will realize $8.1 million less in the first quarter than it would have by just using the floor.

Ryan Zorn, Bonanza Creek’s senior vice president of finance, said that the comparison doesn’t take into account the advantages of the strategy. The proceeds from selling the $68.08 puts helped pay for the protection at $84.32, without which Bonanza Creek would likely have purchased cheaper options with a lower floor.

’Much Better’

“The other comparison is if we’d done nothing,” Zorn said. “I view it as being much better than being unhedged.”

Representatives for Anadarko, Noble, Carrizo and Parsley didn’t return e-mails and phone calls seeking comment.

“Because we’ve had high energy prices for so long, it could have given them a false sense of confidence,” said Ray Carbone, president of Paramount Options Inc. in New York. “They picked a price they thought it wouldn’t go below. It has turned out to be very expensive.”

Callon (CPE)’s first-quarter three-ways cover 158,000 barrels with a floor of $90 and a subfloor of $75, company filings show. Callon, based in Natchez, Mississippi, will get $3.3 million less that it would have realized by using the $90 floor, assuming prices stay where they are.

“Certainly, if we’d had the foresight to know prices were going to crater, you’d want to be in the swap instead of the three-way,” said Eric Williams, a spokesman for Callon. “Swaps make more sense if you knew prices were going to go down the way they did, but a few months ago everyone was bullish.”

To contact the reporter on this story: Asjylyn Loder in New York at aloder@bloomberg.net

To contact the editors responsible for this story: Dan Stets at dstets@bloomberg.net Richard Stubbe

BUSINESS Oil’s Fall Puts a Chill on U.S. Drilling Energy Firms Slash Spending, Staff as Crude’s Decline Accelerates

By LYNN COOK and ERIN AILWORTH WSJ
Dec. 10, 2014 7:15 p.m. ET

U.S. energy companies are starting to cut drilling, lay off workers and slash spending in the face of an accelerating decline in oil prices, which fell to a fresh five-year low Wednesday.

The number of rigs drilling for oil in North Dakota and parts of Texas has started to edge down, new drilling permits have dropped sharply since October, and many companies say they are going to focus on their most profitable wells.

EOG Resources Inc. this week said it would shed many of its Canadian oil and gas fields, close its Calgary office and lay off employees there as it refocuses in the U.S. Matador Resources Co. of Dallas is contemplating temporarily leaving the prolific Eagle Ford Shale area in South Texas in favor of drilling elsewhere in Texas and New Mexico where it can make more money.

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Investors sold off shares of energy companies including EOG as the U.S. benchmark oil price fell to $60.94 on Wednesday. EOG lost nearly 3% to $86.79 while shale specialists Continental Resources Inc. and Chesapeake Energy Corp. both declined about 7%. Many of these U.S. independent drillers have lost half their value since June.

Shares of global energy giants have fared better than the independent U.S. companies because their refining operations are benefiting from cheaper oil. But some of the biggest are disclosing cutbacks.

BP PLC, which has been cutting back since the Deepwater Horizon oil spill in 2010, outlined a further $1 billion restructuring on Wednesday. ConocoPhillips , one of the biggest shale producers in the U.S., recently said it would spend 20% less next year on drilling wells, honing in on its sweetest spots instead of drilling its more expensive areas like Colorado’s Niobrara.

“At this point a contraction is unavoidable,” said Karr Ingham, economist for the Texas Alliance of Energy Producers.

One reason for the stock declines is investors are skeptical: Whatever their plans, U.S. companies produced 9.1 million barrels a day last week, the highest level since 1983, according to federal data. There is so much oil sloshing around the U.S. that refiners can’t use it all, so 1.5 million barrels of crude went into U.S. oil stockpiles last week.

ENLARGE
Some companies will be able to keep pumping even at lower prices, depending on the location and quality of their wells. Enterprise Products Partners LP, which operates pipelines and oil storage terminals across the U.S., said its analysis shows that the average well in many shale formations aren’t profitable at $60 oil. But wells considered high grade can withstand much lower prices. For instance, some wells in South Texas are profitable at prices of $30 a barrel, while the best in North Dakota’s Bakken area can only withstand a drop to under $50 a barrel.

Energy companies’ hedging strategies run the gamut from Continental Resources, which cancelled nearly all its price hedges and projected oil prices would soon rise, to Pioneer Natural Resources Co. of Irving, Texas, which has hedged 85% of its oil and gas output for 2015. Companies that hedged their production aren’t as exposed to falling prices and may not have to pump less or curb spending as quickly.

Surging American oil output has helped create a global glut of oil that has sent prices spiraling downward. The benchmark U.S. oil price, which briefly rose above $107 a barrel in late June, closed below $61 a barrel Wednesday, down 43% since its summer high.

Drilling permits issued in the U.S. dropped 36% between October and November, according to data from Drillinginfo, but remain 13% above their year earlier level.

Another sign of the energy industry’s pullback: the number of rigs drilling for oil in the Eagle Ford Shale in Texas has started to drop. Drilling in the nation’s second most active oil region hit a peak of 210 rigs in July but recently fell to 190 rigs.

These declines don’t necessarily mean that U.S. oil output will fall, said Greg Haas, a director at research firm Stratas Advisors in Houston, because companies are getting more efficient at drilling. “It used to be if the rig count dropped then oil production dropped, but not anymore,” he said.

In a sense, energy companies are a victim of their own success. EOG, Chesapeake and others learned to drill and frack wells faster and wring more from each well. Chesapeake says its initial production at new wells in the Eagle Ford improved by 65% over the last five years.

Houston-based EOG took 22 days to drill a well in South Texas in 2011; today it takes less than nine days. The company recently said it can earn a 10% profit after taxes even if oil prices were to fall to $40 a barrel.

However, companies with a lot of debt, low rates of return and little chance of drilling their way to better profitability will be hurt if crude remains below $75 a barrel, according to analysts at Global Hunter Securities.

Among the companies they cited was Triangle Petroleum Corp. Jon Samuels, president of the Denver-based independent explorer, said his company is profitable at the current price of oil.

Triangle’s shares are down 47% in the last two months. It is pushing vendors for cheaper prices for drilling equipment and contract labor in the new year, which should help bring down costs, he said.

“You’re going to see activity levels and spending go down substantially compared to this year,” Mr. Samuels said, adding that the stock market reaction to crude’s price drop has been overblown.

Write to Lynn Cook at lynn.cook@wsj.com and Erin Ailworth at Erin.Ailworth@wsj.com