Below is a summary of the materials we would typically share if a client were considering hedging in an acquisition. These are usually multiple meetings, detailing (1) the fundamental view of oil and gas prices in the region, (2) the liquidity of the markets and execution of trades, and (3) a numerical/statistical analysis of the asset's price risk.
Summary, 2/10/2023: Waha Basis Outlook: AEGIS believes Waha basis price risk is to the downside, more acutely in the Summer 2023 strip as the basin waits on new egress capacity. In the medium and long term, we expect the basis to remain under pressure as midstream continuously plays catch-up to the growing associated gas supply. Volatility in basis is highly likely, in our view. Click here to go to the basin overview.
The price charts below isolate portions of the forward curve to study their price evolution. Click and drag the mouse to interact. Double-click to reset.
Permian Oil Differentials and Destination
Midland, Houston, and Cushing form a pipeline-connected triangle, and the differentials on each leg depend on both the S&D balance at each location and solving the network of transportation prices.
AEGIS has hedged for dozens of A&D deals, both for the buyer and the seller. Some common themes we have observed, and counseled clients on, are described below.
We created a hypothetical Permian asset with about 10 MBbl/d of production.
You provide:
We provide:
The result:
The charts below display some of the inputs and outputs of this process. We show production volumes of a hypothetical asset. Then, we describe the range of revenue outcomes this asset could generate if unhedged. Last, we provide a comparative analysis of three types of hedges that would make a minimum revenue goal 95% likely to be achieved.
Primary source of risk is both WTI CMA. The following "tornado" chart shows our stress testing of the asset's production. In our 5% downside case (i.e. P95) ALL revenue could fall by 49.1% for 2024 (second chart from left). The upside 5% case (P05) shows an increase of 66.8% in revenue. Our methodology seeks to constrain the downside using minimum hedge sizes.
Below, we look at a three-year horizon, assuming the buyer of the asset would want to secure three years of return via protecting revenue. Unhedged range of revenue is quite wide, as you can see in the "Current" column below. For our fake asset, there would be a 85.5% chance of reaching our fake $252 million revenue goal.
Our aim is to narrow the downside to your revenue target. Swaps, Puts, and Collars are all possible solutions, considering the main risk is WTI CMA. Columns A, B, and C each show the effects of hedges if you follow our methodology for calculating minimum hedges (see the summary table in the next section).
Swaps (Column A) require the lowest volume of hedges and often are the most efficient. Put options (Column B) require more volume but only lightly impair the high-side case if prices rise. Column C is a costless collar. All these hedges target a 95% chance of $327 MM revenue success. Unhedged, the chance of success was only 78.8%.
Swaps would provide not only the most complete protection, but also the lowest volume required and the best efficiency in execution.
In the last year, we have noticed some changes in how hedges are placed in an acquisition. We would be glad to discuss the details behind these:
Strategy | Pros | Cons | Credit (CVA charge) |
Purchase Puts | Protects against downside risk and retains upside | Expensive; Loss of portion of premium if deals falls through | $0.25-$0.50/bbl; $0.04-$0.08/MMBtu |
Purchase Puts Outright of Deferred | Post Close: Sell a call and create a Collar. The premium received from selling the call will help to recoup all or a portion of the premium from the purchased put | Expensive ;Loss of portion of premium if deals falls through | $0.25-$0.50/bbl; $0.04-$0.08/MMBtu |
Purchase Put Swaption |
Cap negative MTM if market declines | Expensive; Loss of premium if deals falls through | $2-$4/bbl; $0.30-$0.60/MMBtu |
Novate Positions | Hedge book already in place | Cost associated with Novation (Dependent upon willingness/Ability of counterparties) | Varies by counterparty |
Swaps | Agressive protection upon close of deal | Wrong way risk if the deal falls through; will need to unwind | Normal credit (varies by counterparty) |
If you face a risk of prices moving between PSA and Close, we should estimate the amount of price risk for that period. If the volatility is too much to bear, we seek hedges that are either conditional (swaptions, for example) or have no potential for creating a liability (put options).
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Basin and Hub Map
Map of west Texas and New Mexico. The Waha Hub is located in Pecos County and is a major physical gathering point for natural gas from the region. Red lines are major pipelines in the area.
Source: WellDatabase
Permian Rig Count
Permian Rig count from the U.S. Department of Energy (monthly)
Infrastructure and Production
We expect the Permian basin's gas supply-demand balance will be challenged in the next few years by the pipeline congestion created by its production growth. The result is periods of volatility and weakening prices, followed by phases of relief as pipelines are built or expanded. The chart above shows how production may interact with pipeline space. Expectation of constraints. Cheaper basis prices, or large discounts to Henry Hub, usually imply some sort of egress capacity constraint or increased need for capacity out of the basin. The weakness for Waha suggests the region could run into takeaway capacity constraints as soon as Summer 23. WhiteWater announced on May 2 that the Whistler Pipeline would be expanded to 2.5 Bcf/d, an increase of 0.5 Bcf/d. Whistler pipeline has gained the final investment decision (FID) and is scheduled to be operational in September 2023. Kinder Morgan announced a final investment decision (FID) on its Permian Highway Pipeline expansion on June 29. The project involves adding compressors on PHP to increase the pipeline's capacity by 550 MMcf/d. The project's target in-service date is November 2023, pending additional customer agreements. Kinder Morgan announced the start of an open season for the Gulf Coast Express expansion on May 16. The project entails adding compressors to the GCX pipeline to enhance its capacity from the Permian Basin to South Texas markets by 570 MMcf/d. The project is expected to be operational in December 2023, subject to additional customer agreements. WhiteWater announced a final investment decision (FID) on its Matterhorn Express Pipeline on Thursday, May 19. It transports 2.5 Bcf/d of natural gas from West Texas' Permian Basin to Houston's Katy area. The 490-mile is expected to be in service in 3Q2024. Energy Transfer proposed their new Warrior pipeline. "Given the proposed route and our ability to utilize existing assets, we believe we could complete construction of (the Warrior) project in two years or less once we have reached FID (final investment decision)," said Energy Transfer's CFO Thomas Long on an earnings call on May 4. Analysts estimate the project to add around 1.5-2.0 Bcf/d of transport capacity with about 260 miles of new pipe from the Permian Basin to the Dallas area. The estimated in-service date is 3Q2024. Kinder Morgan reportedly plans another Permian project called the Permian Pass Pipeline. Analysts estimate the pipeline capacity to be around 2 Bcf/d, and it would transport gas from the Permian basin to Katy, Texas. If KMI goes ahead with the project, it is expected to come online sometime around 4Q2025. |
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