Morgan Stanley’s Sherk stresses value of oil hedging

Options have become good way for E&P firms to raise capital, top banker says

Peter Sherk, Morgan Stanley

Oil-producer hedging programmes have been crucial in helping the US energy industry weather the steep downturn in crude prices and, in the present environment, options transactions have emerged as an important way for exploration and production (E&P) companies to raise capital, according to Peter Sherk, the global co-head of commodities at Morgan Stanley.

"The energy industry right now is struggling. It's in a much tougher spot than it had been and that many had anticipated," said Sherk, speaking at Energy Risk Summit USA on May 17. "In the E&P space, cheap, available capital is a thing of the past in many respects. There is a lot of distress in the debt markets as a result of what's happening with the energy crisis. Hedging has helped."

To illustrate his point, Sherk cited a study carried out by analysts on Morgan Stanley's commodities desk on hedging gains by a group of about 40 mid-sized E&P firms. If oil prices stay roughly where they are now for the rest of the year, hedging gains by the group will total $9 billion this year, he said.

The price of West Texas Intermediate (WTI) futures for June delivery settled at $48.31 per barrel (/bbl) on May 17. Despite a rally over the last three months, that price is still 48% less than the average price of WTI in 2014.

Sherk noted that hedging gains were even more impressive in the wake of the 2008 oil price crash, when front-month WTI futures plunged from record highs of $147/bbl in July that year to less than $35/bbl in December. In 2009, the same group of 40 mid-sized E&P firms in the Morgan Stanley study enjoyed an eye-popping $15 billion in collective hedging gains, said Sherk.

"I had to check that a couple of times because I was astonished that it could be that big of a number," said Sherk. "Prices had fallen so far and hedging had been pretty aggressive. It kept a lot of these companies afloat when they would have gone under were it not for the ability to still service their debt because they had that revenue."

In retrospect, he added, the hedges US oil producers put in place prior to the 2008 crash allowed the industry to begin developing the technology of hydraulic fracturing, or ‘fracking', and horizontal drilling, which began to enter widespread commercial use in 2009–10.

"By hedging forward aggressively, producers were able to borrow a lot of money, they had access to capital and then, when the energy market crashed, they had all of these hedges in place," Sherk said.

Amid the distress in the E&P sector today, he added, derivatives can play a different role: helping oil producers sell their upside to raise capital. Producers should consider the sale of call options as a way to raise capital without the dilutive effect of issuing more equity, Sherk said. Such an approach differs from the more common way in which E&P firms sell call options: the zero-cost collar, in which a firm sells call options to finance the purchase of put options, effectively sacrificing its upside to protect its downside.

"You should look at upside not as a source of funding to protect your downside entirely, but also as a way of generating capital," he said. "I think this is the time. When capital was cheap and readily available it made no sense, but the timing is different now. This is the way we adapt, and maybe this is the way the industry ought to be looking at market opportunities today."