Don't let it get away!
Keep track of the stocks that matter to you.
Help yourself with the Fool's FREE and easy new watchlist service today.
With many mid- to small-cap oil and gas companies suffering net losses in the first quarter because of derivative instruments, Fools should ask how they're being affected.
Commodity derivatives can be a boon or a bane in a volatile energy market. These instruments have the power to massively alter companies' bottom lines, both in a positive and negative manner. In this case, the result was clearly negative. Warren Buffet's financial weapons of mass destruction rear their ugly head yet again.
Why hedge?
Hedging activities, like the ones that utilize the same derivatives that have roiled the income statements of dozens of energy companies, are especially important for companies engaged in exploration, production, and refining of oil and gas.
The primary reason is because of the unpredictable nature of energy prices in the market, which are driven up or down depending on macroeconomic factors that are completely beyond companies' control -- perhaps more so than any other industry.
Not your daddy's supply and demand curve
I must add that by "macroeconomic factors," I do not simply mean the forces of demand and supply. Speculators play a huge role in fixing oil prices. There is little doubt that oil prices were on the wrong side of $100 till last week -- and it all started from fears of a shortage in global supply in the wake of the Libyan crisis in February.
While factors like a weakening dollar and disruptions in production in a major oil producing country are valid, it is fair to argue that speculators play a more significant role behind the unpredictability of crude oil prices. Last week's stunning rally in crude prices following a fall the previous week, which was attributed to computerized trading, shows the power speculators have over the market -- when nothing actually changed fundamentally in between.
Not a recent phenomenon
If that's not sufficient evidence to prove this point, just consider the number of unjustified (and violent) energy-related swings we've had in the last five years alone. No change in energy supply or demand explains the amount of volatility we've seen.
This makes it all the more pertinent for oil companies to hedge their positions to offset potential losses due to a fall in prices, i.e., limit downside risks. That way, there will be a guarantee that the seller will not have to sell oil below a price that has been fixed beforehand, even if prices in the market were to drop below that value during the time of sale.
So what's the point?
As mentioned earlier, sometimes efforts to protect core operations through future sleuthing in the derivatives market works. Sometimes it doesn't. Recently, companies have been on the wrong end of the deal.
Brigham Exploration (Nasdaq: BEXP ) recorded unrealized losses worth $36 million that marred the bottom line. Noble Energy (NYSE: NBL ) recorded unrealized losses worth $303 million this quarter, while these contracts saw them profit $147 million no less than a year ago. Anadarko Petroleum (NYSE: APC ) lost $256 million compared to gaining $588 million last year. Naturally, it saw a drop in net income to $216 million from $716 million -- despite a 34% rise in production over the year-ago quarter.
Continental Resources (NYSE: CLR ) and Kodiak Oil & Gas (AMEX: KOG ) seem to be the worst affected with actual net losses being recorded. Despite this, these Bakken shale oil operators have actually scaled up production and recorded a growth in operating income and efficiency.
Meanwhile, Penn West Energy (NYSE: PWE ) and Valero Energy (NYSE: VLO ) posted profits despite very significant losses related to hedging instruments, perhaps thanks to solid business models and astute management.
How does this affect you?
What effect will these losses have on investors? We'll see. Investors must realize that all losses related to hedging activities may never translate into actual losses -- in other words, cash does not necessarily leave the building every time a company reports a net loss solely because of derivatives.
These losses are simply notional in a majority of the cases -- for now, at least. Time will tell whether these companies will be forced to close out these contracts and recognize these losses or they can capitalize on further volatility in the market. For now, investors can take comfort in the fact that these losses are just on paper.
Foolish takeaway
Oil companies have scaled up production and operational efficiency, which is what Foolish investors need to see out of a potential investment. This is why I'm quite positive about the prospects of these stocks in the long run, despite their short-term struggles with derivatives disarmament. For now, pay close attention. Bottom lines can be deceptive.
With high oil prices in mind, The Motley Fool has created a new, special report; you can download it today at no cost to you. In this report, Fool analysts cover three outstanding oil companies, including the stock Fool analyst David Lee Smith calls the "energy king." To get instant access to the names of the three oil stocks, click here -- it's free.
RSS Headlines
Fool UK
Comments from our Foolish Readers
Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the
Report this Comment icon found on every comment.
Report this Comment On May 19, 2011, at 1:40 AM, snowbrush1 wrote:
The irony in mark to market accounting that is intended to more accurately reflect the earnings of a company is that in a true hedge like BEXP it does not allow for concurrent recognition of the production income that the hedge applies to!
If BEXP had a hedge contract to deliver crude in Jan of 2012 for $86 a BBL and at 3/31/2011 WTI was $106 they were forced to Mark to Market that contract for a $20 loss for Q-1 without any consideration for the revenue from 2012 production the contract was intended to support.
If Q2 ended today at WTI $100, BEXP would be required to recognize a gain of $6 on the hedge because the WTI price dropped! How absurd !!!
In a hedge situation the market to market rules are wrong, counter productive and dis-inform the public.
On the other hand If you or I or Morgan Stanley speculate on WTI crude prices with no hard asset to support our gamble, mark to market would be appropriate.
Good article.
Report this Comment On May 19, 2011, at 1:53 PM, hanover67 wrote:
I own KOG and was surprised by the reporting of losses on derivative contracts. I think these companies should make full disclosure of these contracts so that investors can factor them into their analysis. Airlines disclose how much of their future fuel costs are hedged, why not drilling companies' volume and price deals?
Report this Comment On May 19, 2011, at 3:07 PM, snowbrush1 wrote:
Derivative contracts are disclosed. The problem is that the press in look of headlines and lacking understanding of the positive role that hedges play in Oil and gas production or other commodity intense, long term asset industries, continue to blindly think of every company as a Wal-Mart that can ramp up or ramp down sales with a call to the warehouse.
And, too many investors trade O&G Companies whose lively hood and value is based on 30 year wells up and down with every 10 cent move in the WTI. Stuuuuupid !
Report this Comment On May 19, 2011, at 6:15 PM, badbernanke wrote:
Derivative accounting reporting requirements are a mess.
Requiring producers who hedge (at prices typically at levels which provide profitable and stable operations from a cash flow standpoint) to report losses from derivative contracts relating to future production and reporting those "losses" as reductions of revenue in the current period is terribly misleading.
Over the last four years, we have seen oil rise to $140 /bbl, which caused producers to recognize huge losses on derivative contracts that extended out three to four years. Then oil fell to $30/bbl and those same producers had to claim huge hedge profits. Then oil went back to $120 and more "losses". Now prices have retreated to $100 or lower and there are "gains". All paper gains and losses. None affecting the business operations.
For producers, "losses" occur when oil prices rise and "gains" occur when oil prices drop.
I would argue that periods of paper hedging "losses" are typically better than periods of hedging "gains" because for a company with a growing production profile (e.g., CLR and BEXP), the non-hedged and growing production is being sold at top dollar and the revenue flow to the entity is at its maximum.
Report this Comment On May 20, 2011, at 11:47 AM, OlJim wrote:
Though it appears impossible toaccomplish, I would like to see an end to oill speculation. Period. Remove it from the commodities exchange markets. Oil, (next to air, water and food), is an essential in today's world. And the fundamental pricing should be around $32-40 per barrel. That would permit the nation's (and the world's) economies to flourish. This obscenely overpriced commodity, driven by non-existent forces, is (again) driving the US economy into a tailspin. I said this in 2008, and here it comes again, 2008/2009 "recession", Round II. All those folks who defaulted on their excessive mortgages a couple of years ago, were able to make their payments, until their monthly fuel bill quadrupled, and the $300-400 more per month they had to spend on gasoline was the straw that broke the camel's back. I so badly want to see hedge funds and oil speculators take a brutal hit. I want to see losses in the hundreds of millions, by all who have pushed oil this absurdly high. The large gains by a very few, at the cost of millions of hard-working folks, is NOT capitalism at it's finest, but at it's worst. WHat will the few who made so much do, when people stop spending money on everything but the barest essentials, because that is all they can afford? Greed is bringing the best parts of our American way of life to it's knees... (A lifelong, hard-core Republican, pro-business, pro-Free Enterprise loyalist, who is totally disgusted with what Oil and it's speculators are doing to this country).
Report this Comment On May 20, 2011, at 9:44 PM, ershler wrote:
OlJim,
Free-market capitalism usually destroys itself. The S&L and recent financial crisis are just two recent examples. It will be interesting to see what happens when (not if) the market-authoritarian model becomes the dominant system in the world economy.
Report this Comment On May 21, 2011, at 10:25 AM, isacsimon wrote:
@snowbrush1
<<In a hedge situation the market to market rules are wrong, counter productive and dis-inform the public>>
Yes, I'd agree with this. There has to be a more foolproof mechanism to reflect the fundamental operations of oil & gas companies.
-Isac Simon
Report this Comment On May 21, 2011, at 10:26 AM, isacsimon wrote:
@snowbrush1
Thanks!!
Fool on!
-Isac
Report this Comment On May 21, 2011, at 10:33 AM, isacsimon wrote:
@badbernanke
<<Derivative accounting reporting requirements are a mess>>
Agreed! And yeah, in that sense, "losses" are better for growth companies.
-Isac
Report this Comment On May 22, 2011, at 11:31 AM, snowbrush1 wrote:
@OlJim
Hedging provides both an orderly cash flow for an O&G producer and security for his banker to lend for drilling more of this depleting resources. Accordingly, Hedging by a producer provides a valid and necessary function.
What no seems to recognize is that on the other side of nearly every hedge contract is a speculator. Yes a refiner may hedge the purchase but the speculator provides a buyer when the refiners provide an inadequate supply of sell contracts. The needs to hedge of a refiner and that of a producer are entirely different due to size, credit line dependencies etc.
The simple fact that the producer with each well is making a large investment that will return over 30 years contrasts his needs from that of the refiner. The Refiner is much like WalMart going to his supplier to provide product on demand. This is a huge difference in the dynamics motivating each of them to hedge. Thus the speculator provides an important and necessary role in the middle.
Add your comment.