The Oil and Gas Addendum

There is no way to avoid it. It seems like everything costs more now than it did last week, last month and last year. Energy is one area with very sensitive prices. You have likely experienced the significant changes in gasoline prices over the last 2 years. Given the sensitivity of energy markets to global events, price hedging is often used by producers and large consumers to gain business certainty.

Airlines need a lot of jet fuel to operate their business. Just like gasoline, the price of jet fuel goes up and down and varies in different regions. A Bloomberg article discussed airlines’ practice of “hedging” jet fuel. Basically, a “hedge” describes an array of financial tools that companies, like airlines, can use to get pricing certainty for a particular product or commodity, like jet fuel. Mercatus Energy Advisors has an introductory explanation of different “hedge” products and its article “An Introduction to Airline Fuel Hedging Strategies - Swaps” is a good starting point. The article address what a “swap” is and how it is used in the aviation sphere. At a basic level, “A jet fuel swap is an agreement whereby a floating (or market) price is exchanged for a fixed price”. This is just one type of price hedging, and its goal is to turn “uncertainty” into “certainty” with respect to this input.

But, while price hedging instruments can provide cost certainty to a company, they do not protect against all losses. As Alex Longley and Devika Krishna Kumar at Bloomberg report, “Fresh from losing billions of dollars from bad oil-price hedges because of Covid, many of the world’s airlines are once again trying to protect themselves from soaring fuel costs” by hedging jet fuel. Price hedging does not take all the risk out of conducting business, but it allows for much greater predictability and avoiding exposure to rapidly changing prices.

Naturally, in a price hedging agreement, there have to be two sides. Just as consumers like airlines are looking for price certainty, fuel producers also look for certainty that price hedging can provide. This is where oil and gas royalty owners should take note. Oil and gas producers also use price hedging to gain predictability for their sales values. An October 15, 2021 article in Bloomberg by Gerson Freitas Jr. summarized an issue recently facing EQT Corporation:

The Bloomberg author stated that “EQT is hardly alone in hedging much of its output: collectively, expected hedging losses for U.S. producers through 2023 stand at $34 billion, BloombergBNEF estimated this month.” Getting back to EQT, the article states that “As of the end of June, EQT had hedged about 80% of its output through next year below $3 per million British thermal units. Benchmark futures have averaged about $4.50 since the end of June and touched a 12-year high above $6 earlier this month.”

Oil and gas drillers utilize hedging as a form of insurance to minimize risk in a volatile market.  This is especially true if the driller is concerned about falling prices – they can use financial instruments to hedge against the possibility that gas might be worth less in the future.  How does hedging work in the oil and gas industry?

Let’s assume XYZ Drilling expects to produce 500,000 Units of gas in November and has contractually committed to sell that volume of gas based on the floating Transco index price.  Given the volatile market, XYZ Drilling decides to hedge 100% of this production at a fixed price of $3.50 per Units to lock in a revenue stream of $1,750,000.  Pursuant to the hedging instrument, XYZ Drilling contractually agrees to pay the counterparty (i.e., the party offering the hedge arrangement) a percentage of the floating spot price in order to obtain the certainty of a fixed commodity price (i.e., the hedge price). Here’s how it works:  If the Transco index price is $4.00 per Units at the time specified in the hedging instrument, then XYZ Drilling owes the counterparty $250,000 (i.e., the product of the spot index price ($4.00) minus the hedge price ($3.50) multiplied by the production volume).  Assuming XYZ Drilling sells the November production at $4.00 per Units, XYZ Drilling realizes $2.0 million in revenue (i.e., $4.00 per Units multiplied by production volume).  After the payment of $250,000 to the counterparty, XYZ Drilling still achieves its target revenue threshold of $1,750,000.  Now, let’s now assume that instead of trading at $4.00 per Units, the Transco index price is actually at $3.00 per Units.  Under those market conditions, the counterparty would pay XYZ Drilling $250,000 (i.e., the product of the hedge price ($3.50) minus the actual spot index price ($3.00) multiplied by the production volume).  If XYZ Drilling sells the November production at $3.00 per Units, the actual sales revenue is only $1,500.000.  But, because of the hedging transaction, XYZ Drilling is insulated from the price drop and receives an additional $250,000 from the counterparty.  As such, XYZ Drilling’s target revenue threshold of $1,750,000 is still satisfied.

As noted, many drillers use price hedging to gain price certainty on at least some of their production volumes. But, hedging practices can raise legitimate and troubling questions regarding landowner royalties:

• First, is the “price” in the royalty statement the “price” that was obtained from the actual sale of the hydrocarbons or is it the fixed “price” from the hedging position?
• Second, leases vary in their description of “what” the royalty is based on and “how” it is calculated. Royalty owners should evaluate their specific royalty clause to determine “what” price their royalty should be based on.
• Third, when drillers “hedge” volumes at known prices, that can lead drillers to continue to produce and sell gas during pricing downturns or, correspondingly, disincentivize additional drilling and production during times of high prices. 

The impact  of price hedging is particularly alarming in connection with market enhancement clauses.  These clauses typically prohibit the deductions of any post-production costs that are incurred transforming the gas into marketable form.  Once the gas is in marketable form, these clauses generally allow a driller to deduct further costs only if those costs enhanced the value of the gas and enabled the driller to get a “better price” for the gas.  The drillers argue that by moving the gas further away from the well-pad, they can reach distant markets, and, perhaps, better pricing for the gas.  In other words, according to the driller’s narrative, the simple movement of gas constitutes an enhancement cost that is deductible from the landowner’s royalty. 

However, hedging calls into question whether the driller is really moving the gas to obtain “better” pricing.  If the driller is insulated from price fluctuations and market volatility by virtue of the hedging instrument, what motivation does the driller have to obtain a better (i.e., higher) price for the gas?  Does the driller really need to move the gas 350 miles away from the pad site simply to net a marginally higher price?  Because the revenue stream is “protected” by the hedge, the driller simply has to sell the gas at any price.  The purported transportation and movement costs are, therefore, not being incurred to obtain a “better” price as required by the market enhancement clause.  Whether the gas is sold locally at $3.25 per Units or 350 miles away at $4.00 per Units does not matter – the hedge position locks in a fixed commodity price.  Under these circumstances, the cost to move the gas is simply a necessary operational cost and cannot be viewed as an enhancement of the gas.  As such, the transportation costs should not be deductible.

While drillers may participate in price hedging to gain business certainty, these practices may raise more questions and concerns for royalty owners. Royalty owners should review their royalty clauses, research drillers’ price hedging positions in public databases and consult with experienced oil and gas counsel if it appears that the pricing and cost information reflected in their royalty statements are inconsistent with the purported hedge positions.