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.
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.
Meanwhile, Penn West Energy
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.
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.
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