This One Oil Bet Has Producers Kicking Themselves

Hasan Jamali/Reuters

There's a story from Bloomberg this morning about oil producers and how they hedged prior to the price crash that is really good for understanding the way American shale producers have thought about the oil market up until this point ("Drill, baby, drill!" seems to be it, mostly). It's also a pretty clear explanation of some of the finance going on in energy right now. 

"You're not going to go drill holes in the ground if you think prices are going down," is how a Houston-based hedging consultant described producers' thought process to Bloomberg. But down they've gone. So what now? 

As the price of oil drops, a lot of American producers have been saying that in the short term low prices are fine, because they're hedged. But they also took some risks with those hedges that are not turning out so well for them lately.

The basic idea is that the producers were so bullish on the price of oil they didn't do straight swaps to hedge for price swings, but instead did what's called a three-way collar (sometimes called "three-way costless collars"), where they sell additional put options at a lower price than the floor of the original collar. So instead of a floor and a ceiling for prices, there are two floors and a ceiling.

Selling put options for that lower floor makes the whole trade cheaper for producers (and/or allows them to buy more expensive options to raise the prices of the original collar) - unless the price of oil goes below the floor, in which case they start losing money. And for a lot of producers, that's where we are now.

Here's how it works in practice, from the Bloomberg story: 

Pioneer used three-ways to cover 85 percent of its projected 2015 output, the company's December 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.

Is this bad? Eh, it's better than being unhedged for sure. Obviously there are disadvantages, like all the money left on the table by creating that extra floor. But that's the nature of the game. 

Anyway, it's something to pay attention to if oil prices stay below $70 for a while.