Oil prices have fallen precipitously during the last month or so. That's bad news for oil companies. For example, Royal Dutch Shell plc recently warned investors that the price drop hasn't fully worked its way through the company's earnings yet. Worse, the international driller's low-end target for oil is $70 a barrel, suggesting oil could still have room to fall. 

It's a good thing that LINN Energy LLC (NASDAQOTH:LINEQ), Vanguard Natural Resources, LLC (NASDAQOTH:VNRSQ), and Breitburn Energy Partners L.P. (NASDAQOTH:BBEPQ) have all locked in high prices via their extensive hedging activity. While that's good news for now, it could turn into a hedging cliff if prices don't recover.

The oil impact
Commodity prices are volatile, and oil is no different from the rest of the pack. Brent Crude has now fallen from around $115 a barrel, as recently as June, to around $76. That's a potential problem for companies that drill for oil, though not all will be affected equally. For example, Vanguard Natural Resources derived about 15% of its third quarter revenues from oil, LINN Energy roughly a third, and Breitburn nearly 60%. 

Brent Crude Oil Spot Price Chart

Brent Crude Oil Spot Price data by YCharts

With the oil drop, Breitburn clearly has more at risk then the other two distribution-focused drillers. And that's an interesting fact to consider here, Breitburn, LINN, and Vanguard all pay out most of what they make as dividends. So a drop in oil could have a rather nasty impact on their ability to pay distributions.

That said, production and revenue are two different beasts. For example, through the first nine months of the year Vanguard's oil sales made up roughly 45% of its top line... despite accounting for only 15% of its production volume. Oil revenues were roughly two thirds of LINN's revenues over the same span and roughly 80% at Breitburn. So oil prices are a bigger issue for this trio than production alone suggests, with Breitburn particularly exposed to oil's drop.

Covering your...
It's a good thing that LINN Energy's hedging program has locked in oil prices in the $92 a barrel area for the rest of this year. Vanguard and Breitburn have locked most of their oil at around $93 a barrel. Indeed, their main goal is to protect distributions and limiting the impact of often-volatile energy prices is just good business.

With oil prices relatively low, this trio looks like they'll be a safe haven for income investors right now. And all three offer impressive yields of 10% or more. But hedging isn't a cure all. For example, Breitburn has locked in roughly two-thirds of its oil production for 2015 at $92 a barrel, with nearly 60% hedged for 2016 in the $89 area. LINN has roughly half of its oil hedged in the $90s during the next two years. And Vanguard has roughly 70% of its oil hedged in the 90s for 2015, and around a third for 2016. This should help each of these distribution-focused drillers to keep paying shareholders.

(Source: Chappell, Oil City, Pennsylvania, via Wikimedia Commons)

However, what happens if oil's decline gets worse, or prices linger at relatively low levels? Shell's call for $70 oil is 20% below the $90 range that this trio has prices locked in at. With oil breaking through $80 a barrel, its going to be hard to match their existing hedge prices right now. In fact, LINN CFO Kolja Rockov responding to a question about the hedging market during the company's third quarter conference call said, "But I can tell you that we haven't really been in the market, given the precipitous drop." 

The longer oil prices stay low, the more likely that investors in LINN, Vanguard, and Breitburn will face a hedging cliff and the risk of a distribution cut. That will start to show up next year to some degree, but should really become an issue in 2016--particularly for Vanguard, with just a third of its oil production hedged for that year. Breitburn, though most exposed to oil, appears to have the best hedged position. Still, at 60% of its 2016 oil production hedged, distribution coverage isn't a lock if oil prices keep heading lower. Growing production could help soften the blow, but production would have to increase a lot to make up for a 20% drop in prices.

Income investors seeking high yields should clearly take a look at this well-hedged trio. However, you'll need to keep a close eye on the hedges, because that's what will protect or doom your dividends.

Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends BreitBurn Energy Partners. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.