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Continental Resources' CEO is making a big wager that OPEC cuts oil production, but that bet could quickly incinerate the company's entire profit.
Continental Resources (CLR +0.00%) CEO Harold Hamm is starting to become a household name. He's in the middle of a very public divorce that recently saw his ex-wife win a $1 billion award. While she's now appealing and seeking a greater share of his assets in a move that could make her richer than Oprah Winfrey, he's busy going toe-to-toe with OPEC. Not only has Hamm publicly called the cartel of oil-producing nations a "toothless tiger," but he's betting his company's future on rising oil prices by scraping Continental Resources' oil hedges. This move netted the company $433 million in one-time profit, but that profit could go up in smoke if he's wrong. Even if it doesn't, it doesn't make any business sense as it leaves investors overexposed. Hamm seems to be putting his views above protecting investors interests.
Burning the insurance policy
Oil prices have been in the news of late after plunging to four-year lows. That being said, the price of oil is notoriously volatile, so such plunges are to be expected. As the following chart shows, prices can rise and fall surprisingly fast.
Brent Crude Oil Spot Price data by YCharts.
Because of this volatility, oil producers will hedge some future production to protect a portion of their cash flow. These hedges act as an insurance policy against a big downdraft in oil prices, much like what we've seen in recent months. While hedging doesn't eliminate all the risk of falling oil prices, it does help to mitigate that risk.
For example, before liquidating its oil hedges, Continental Resources had 24.6 million barrels of oil hedged with swap contracts at $100.85 per barrel in 2015. That represents less than half of the company's projected oil production next year. Given that volume, oil prices would only need to drop by about $10 per barrel from where Hamm eliminated the company's hedges, and stay at that level for the year, to burn through the gain recorded by selling the hedges early. Sure, that's still a nice cushion, but given how quickly oil prices have already plunged, there is no way of knowing that they've hit bottom. This move could easily blow up on Hamm.
Catching a falling knife
Hamm, however, is betting not only that oil won't go any lower, but that prices will rise from here. He said that:
Harold Hamm. Source: Flickr user David Shankbone.
We view the recent downdraft in oil prices as unsustainable given the lack of fundamental change in supply and demand. Accordingly, we have elected to monetize nearly all of our outstanding oil hedges, allowing us to fully participate in what we anticipate will be an oil price recovery.
While it's quite possible that oil prices have hit bottom and will bounce back, the risk is extremely high that OPEC keeps pumping oil at its current production rate, pushing prices even lower.
Many of Hamm's peers in the oil patch actually see that as a more likely outcome. For example, Scott Sheffield, CEO of fellow U.S. oil producer Pioneer Natural Resources (PXD +0.00%), believes OPEC doesn't have any choice but to keep production at current levels. He pointed out on his company's recent quarterly conference call with investors that because of the makeup of OPEC these days "it's going to be a lot tougher for OPEC to come to an agreement to cut production." Instead, his view is that OPEC has decided that its best interests lie in "putting pressure on the U.S. shale oil revolution," because it would rather keep market share than cut prices.
This is why Sheffield's company is taking the opposite approach by increasing its own oil hedges. The company now has 85% of its oil production hedged through the end of next year, with 45% of its 2016 production also hedged. He's not willing to take any chances that oil prices haven't bottomed yet by playing it safe, rather than trying to "catch a falling knife," so to speak.
Investor takeaway
Continental Resources is playing a dangerous game. The company is basically cashing in its insurance policy before the full extent of the damage to the oil market is known. This move could have a big impact on the company's financial flexibility, as a further slide in oil prices could easily incinerate the gains it made by selling the oil hedges early.