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Recently, Crescent Point Energy (NYSE:CPG) recently released its summer quarter earnings report. Overall it was quite positive, as you’d expect of an oil company in the middle of a massive global oil supply dislocation. I took a look at the company to see if perhaps it would be worth an investment in the always volatile and risky world of oil.
Strong Earnings, One Major Curveball
Crescent’s earnings report was very strong, with both the balance sheet and income statement much stronger than a year ago. I did find one point of concern in the ensuing earnings call with management.
One particular point that was called out was the change in CPG’s hedging strategy heading into 2023. While Crescent has typically hedged around 50% of its book or even more, management intends for that number to fall to around 20% heading into next year.
On its face, this seems like a defensible choice. Crescent has had to watch as a considerable portion of its 2022 production profits have gone to Wall Street traders rather than its shareholders, with the Ukraine War driving oil prices far above where Crescent probably thought they would be when it entered into the current round of hedges. In the most recent quarter, hedges cost the company almost CAD $261 million – over a fifth of its revenue.
Even the fraction of the price hikes they’ve been able to pass through to their own books, however, has been enough to substantially reduce the company’s debt load, making hedging less essential to protecting the company’s balance sheet going forward. So management seems comfortable with – and determined to stick to – its decision.
But that same balance sheet improvement also illustrates how even a strong hedging program does not prevent an oil company from cashing in on an oil boom, it merely caps some of the upside in exchange for strong protection to the downside. This hedging decision by management leaves me very hesitant to invest in what would otherwise be a strong candidate for a Buy recommendation.
The Virtues of Hedging
Over the long term, since oil is a globalized, fungible market and all oil companies should receive more or less the same price, an oil company’s stock price should be determined by its operational excellence and the quality of its individual reserve book.
In the medium-term, it may reflect primarily the transportation differential, affecting what price the company is able to secure minus operational and transportation costs – what the industry refers to as “netback” – as US oil companies in the Permian Basin learned the hard way for years when they grew too fast for their regional pipeline system, effectively transferring profits to the midstream operators as limited capacity was bid up by shale companies like Pioneer (PXD) and Devon Energy (DVN) almost to their break-even point.
Removing hedges, however, effectively swamps all these factors and makes a stock purchase in that company at any given time little more than an implied bet on oil prices. In the short run, differences in operational excellence or even pipeline bottlenecks almost never prove capable of outweighing oil price volatility. A $2 pboe reduction in drilling costs or a $5 reduction in pipeline costs simply can’t compete with a $30-$40 swing in the price of the underlying product.
Unhedged Oil Stocks Aren’t Really Stocks…
It’s precisely for this reason that I always hesitate a little more when considering an investment in a relatively unhedged energy company. Hedges may seem aggravating when prices are rising, but they’re a lifeline when prices are falling so that is pretty much a wash. The real impact of hedging is that it nullifies the short-term factors that are outside the control of investors and management. It makes a bet on an oil company what a bet on any company should be: a bet on that company’s excellence, business model and operational skill.
…They’re Futures
If an oil company is not going to hedge a very considerable portion of its production – by which I mean considerably more than 20% – it is no longer really that company you are betting on when buying their stock, in my opinion. An investor at that point is making a bet on the oil sector more broadly. In which case why not buy the whole energy sector through an energy ETF (XLE) or a pure ETF like (OIL) for example? Indeed, at that point, one almost wonders if it doesn’t make more sense to just buy some oil futures (CL1:COM) directly, if it’s a bet on oil prices you want to make.
Oil Market Price Prospects
Regardless, lower hedging is the choice management has made. This means that they are effectively betting that oil prices are going to be higher when their oil actually makes it to market than the price they could lock in now.
That bet may be questionable. Oil prices just fell back below prewar levels for the first time, and the EU’s planned oil ban is looking less and less likely to actually make a significant dent in global supplies, largely thanks to the US, which has never been sold on it and now appears almost to be actively attempting to undermine it and replace it with its own scheme – one which seems far less likely to produce any significant reduction in supply.
The Slackening Sanctions
From the beginning, the Biden Administration – which hasn’t so much led a charge on sanctions as been pushed into them – has been trying to nudge the EU off of banning Russian oil. No doubt in part since projections were such a ban would take oil prices to $185 per barrel, or even more. Since it’s considered politically unacceptable to fail to support Ukraine or be soft on Russia, Biden and Treasury Secretary Janet Yellen have been pushing a “price cap” system as an alternative.
Under this proposal, beginning the same day as the scheduled oil ban, an exception would be created allowing Russian oil to re-enter the market – effectively nullifying the ban the day it went into effect – as long as it complied with a new G7-mandated price cap. The idea is to lower oil prices with higher supply and lower Russian oil revenues further still with the price cap.
The Administration is careful to always couch such proposals in concerns about making sure that Russian oil revenue does not increase, although one has to assume the impact on inflation domestically is at least as large a consideration. But the practical effect of this proposal is likely to be that no Russian oil ever actually leaves the market – the primary reason oil would be bid up in a time of a global economic slowdown and a rapidly rising dollar.
The US government is extremely insistent that such a price cap system can work, although frankly, they’re just about the only ones who think that, in my opinion. If it does, Russian oil stays on the market. If it doesn’t, as seems more likely, the most likely cause of failure is that India, China and others are helping Russia get around the cap – in which case such smuggling would also ensure that little to no Russian oil left the market.
Risk Of Russian Retaliation Does Remain…
The market may be getting tired of the boy who cried wolf at this point anyway. Back when the Ukraine War first started, 3 million barrels a day of Russian oil production was supposed to be shut in by May, just on the strength of the “energy sanctions risk” that was supposed to have all buyers shying away from Russian oil before it was even sanctioned.
Needless to say, it didn’t turn out that way. Russian oil curtailment seems to have peaked at 1.3 million bpd and is even less now – hence the decline in oil prices.
To be sure, there absolutely is a scenario where oil prices rocket up instead of sliding down. If in fact a G7 price cap system is actually implemented in an effective manner, Russia may very well choose to simply stop exporting oil altogether to certain countries, a decision which could send oil up to $200 per barrel or even higher depending on how many countries and how much oil they stopped exporting. A worst-case scenario could see prices shoot to a staggeringly high $380 per barrel according to some!
…Unlikely US Would Provoke It
It’s hard to picture that, though, frankly. The Biden Administration simply doesn’t want to go this route, in my opinion. Even before the ban was official, senior Treasury officials were already quietly assuring that they wouldn’t support any secondary sanctions on China or India in connection with the proposal, effectively rendering it toothless out of the gate. Efforts to block Russian oil exports even into Western nations have already been rolled back quite a bit from their April/May enthusiasm, as the reality of inflation starts to bite in Western capitals. Third-party countries like China and India are now all but encouraged to ignore Western sanctions and get Russian oil onto market.
There are other potential downsides to oil prices as well. The Democratic climate bill was actually surprisingly solicitous of oil drilling, accelerating permitting and opening new areas of Alaska and the offshore area to drilling. Individual states may take further action. And the Administration is now considering using the SPR as a price-floor creator for oil companies in the US, removing their chief production risk that peace in Ukraine will send prices plunging back down.
Implications For Other Investments
I have in this article given both some specific analysis of Crescent as well as some more general statements of how I approach potential energy sector investments. Any general statements, of course, need to be qualified by the fact that each company can be and is slightly different from its peers.
In assessing the impact on oil companies of hedging, I am of course excluding integrated oil supermajors like Exxon (XOM) and Chevron (CVX) who can use oil internally in their own operations and don’t necessarily have to sell every barrel. Obviously, such companies effectively have “internal hedges” that means their risk exposure to oil prices isn’t a straight line from their production levels. And the impact on shale companies like APA (APA) of oil price movements may be somewhat different if the Biden Administration is successful in providing a taxpayer-funded floor on oil prices for American oil companies.
I stand by my view, however, that in good times and bad a hedged energy producer is, to me, preferable to an unhedged one.
Investment Summary
In general, I’m not a fan of running with low hedges on an oil book. But I’m especially not a fan of it when the risks of further downside moves in oil prices seem so real. It’s always risky locking in an oil price for management, because if you lock in and the price shoots higher you’re missing out on gains, but if oil falls you’re rarely getting applauded because your stock is probably just falling less, not actually rising. But I think this decision to reduce hedges is a mistake.
While I have no complaints about Crescent’s operational capabilities, I won’t be opening a position. I rate it a Hold.
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