Here's the complex and expensive way some oil producers are guarding against plunging prices
- Companies such as Hess Corp and Cairn Energy as well as countries including Mexico use a hedging strategy to keep selling crude oil at higher prices, even when US and global benchmarks tank, The Wall Street Journal reported Friday.
- Hedging is a complicated and risky practice that allows producers to lock in a future price, protecting against falling oil prices.
- It's paid off for some producers amid a historic rout in the oil market that sent the price of West Texas Intermediate into negative territory Monday.
- Read more on Business Insider.
Amid oil prices plunging to historic lows, some companies and producers have used hedging to protect against losses.
By using hedging, companies such as Hess Corp and Cairn Energy as well as countries including Mexico are able to keep selling crude oil at higher prices, even when US and global benchmarks tank, The Wall Street Journal reported Friday.
Hedging is a way to use futures contracts to manage different types of risk. Here's how it's generally used in the oil industry: A company or producer uses futures contracts to essentially fix or lock in a price for a certain volume of oil the group expects to deliver during a set time period.
If oil falls below the agreed-upon price of the contract, the bank or other counterparty in the hedge makes up the difference.
Thus, when the price of oil drops significantly, hedging gives companies and producers some protection against losses. However, it can also include risk — if the price of oil soars, companies and producers may lose money.
Oil prices plummeted to record lows this week, with West Texas Intermediate for May delivery closing at negative $37 per barrel Monday, meaning sellers were paying buyers to take the commodity. Oil has been weighed down heavily as the coronavirus pandemic cratered demand — even historic production cuts from OPEC and allies have done little to boost the price.
Since Monday's plunge, both WTI and international benchmark Brent crude have recovered some losses, but are both down about 73% and 68% this year, respectively.
Lately, Mexico has profited greatly from using such a hedging strategy against falling oil prices, according to The Journal's report.
The country will reap as much as $6.2 billion amid the rout, President Andrés Manuel López Obrador said Wednesday, according to The Journal. Mexico used a trade developed in the 1990s called the Hacienda Hedge, which allows it to sell oil at $49 per barrel. The country has paid as much as $1 billion a year in options negotiated with oil companies and banks, the report said.
North American producers also hedge heavily, according to the report. About one-third of North American oil and production is hedged at $52 per barrel, The Journal reported, citing IHS Markit.
Hess said it has hedged about 80% of oil production, mostly at $55 per barrel for WTI, according to the report.
Going forward, this kind of hedging will become virtually unavailable to companies looking to protect against the oil market crash. Adding hedges will be much more challenging in the remainder of the year due to the downward shift in the curve and the increase in volatility, IHS said, according to the report.
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