In our last post, we addressed natural gas producers' tendency to be overly optimistic, how it exposed many of them to unnecessary risk, and caused them to to miss opportunities. We used the previous decade’s natural gas price peak and trough to demonstrate the point. Current crude oil prices provide us with a real-time example of a similar situation.

Coincidentally, RIGZONE recently published an article (“Is the US Tight Oil Market ‘Too Robust to Bust’?”) about the margin between current oil prices and industry analysts’ estimate of breakeven for major producing basins. Specifically referencing light tight oil plays, such as the Bakken and Eagle Ford, the article quotes an industry analyst,

“With Brent crude oil pricing in the…range of $108 per barrel of oil…almost all tight oil proven reserves are commercially viable, even if global oil prices fell toward $75/bbl, over 70 percent of U.S. tight oil reserves would remain economic."

The analyst goes on to discuss his firm’s view that the tight oil market is “too robust to bust,” and how they do not believe it likely that the current oil production boom could collapse in the near future. With what we know today, it is difficult to disagree. US oil production seems poised to remain strong for the next few years. Taking that argument to the next logical conclusion, prices, too, should remain relatively stable for the next couple of years.

What if they don’t? What if prices unexpectedly drop? How far do prices have to drop and for how long do they have to remain depressed, even if it defies industry fundamentals, for your company to feel the pressure? Better yet, how far do prices have to drop for you to regret not protecting your margins (as a producer)?

Conversely, what if prices spike? As a consumer, how far can energy prices rise before you feel pressure? How long can your company continue to operate profitably if prices stay higher than analysts suggest is warranted based on market fundamentals?

History is loaded with examples of fundamental analysis that seems sound at the time, but is based on assumptions that prove wrong. In fact, the analyst interviewed in the RIGZONE article hedges his comments a few times, pointing out how they reserve the right to be wrong.

We would argue that the primary function of a strong hedging program is to protect the company against unknowable and/or undesirable risk. The market may offer >$25/BBL in margin today, but a CFO is responsible for preparing the company for a market envrionment that is less generous in the future. To reiterate from the concluding paragraph of our previous post:

“Hedging should not be a binary decision – to hedge or not to hedge. At regular intervals, companies should consider the market environment and have a specific set of rules that guide decisions based on company risk tolerance and corporate strategy. This is the best way to remove emotion and bias, as well as prevent speculative behavior that allows said emotion and bias to influence hedging decisions.”