Marathon Oil (NYSE:MRO) provided an update on both its capital budget and its latest hedging strategy this month. Taking a closer look at the company’s hedging strategy will help investors see if MRO stock is going to rise or fall.
Two weeks ago, I analyzed MRO stock based on its projected cash flows from the April 8 update. I wrote that the stock offered good value, even assuming a 40% hit to free cash flow. The dividend will be well covered and the dividend yield of over 4% is an attractive play.
But now, as I look closer at the company’s hedging strategy it seems to have some significant money-losing hedging positions. This could account for why MRO stock has been falling. Investors realize that the company needs to get out of some of these trades.
Looking Closer At MRO’s Hedging Strategy
Marathon Oil also provided a glimpse into its hedging strategy on April 8. It also will update its Q2 hedging strategy on May 6 with the company’s Q1 earnings release. I wanted to examine the hedging strategy a little closer to see what clues it gives us about future earnings for MRO stock.
The April 8 release described the company’s basic hedging strategy for a portion of its total crude oil production. It details the company’s put and call strategies, as well as its swap strategies.
The strategy provided by Marathon Oil shows it hedged 80,000 BPD of crude oil production for Q1 on the New York Mercantile Exchange (NYMEX).
Marathon produced 380,000 barrels per day (BPD) of oil during Q4. Let’s assume that its production in Q1 is down at least 30% or 266,000 BPD in total. That would mean that its crude oil hedges cover 30% or so of expected Q1 oil production.
For the purposes of this discussion, “ceiling” refers to the exercise price at which Marathon Oil sold calls against 80,000 BPD, while “floor” refers to the price at which the company bought puts for the same amount of production.
Therefore, if the price of oil falls between the $66.12 ceiling and the $55.00 floor (i.e, the “collar”) Marathon Oil’s two-way contracts would have been successful. In fact, if oil fell below $55, its bought puts would have continued to be successful – i.e., Marathon Oil would have effectively sold oil at those levels.
Three-Way versus Two-Way Collars
But, this is not all. Marathon put on a “three-way” collar position, popular with oil companies. This third element of the hedging strategy makes the total collar presently not profitable. Here is why: Marathon sold puts for 80,000 BPD crude oil at $47.75. What this means is that Marathon is obligated to buy 80,000 BPD at prices of $47.75 or below.
Ouch! As we know, WTI oil prices during Q1 fell well below $47.75. These sold put contracts are now losing money since crude prices are well below $47.75. We will find out how much Marathon Oil lost on May 6, assuming it did not try to exit these losing contracts.
Assuming it did not close out this third element, I estimate losses will mount. On 30% of Marathon’s production, this could be as much as $20 to $23 BPD or greater on 80,000 BPD. That could result in losses of $166 million or greater during the quarter (i.e. 80,000 x 90 days x $23). And this would be on top of losing money for the rest of its production. This portion of its production likely has a higher cost than the present price of crude oil.
Marathon’s Q2 Hedging Strategy Looks Profitable
Now, look at its Q2 hedging strategy. At least Marathon has not sold puts on 80,000 BPD, the third money-losing element of the collars. In fact, the “floor” price or the price at which it bought puts, not sold them, is $32.89. This is clearly a profitable trade for the company since WTI oil during Q2 has been well below $32.89. This strategy in Q2 will help reduce the Q1 losses.
However, Marathon appears to have again sold put contracts at $48.00 for 80,000 BPD of its Q3 and Q4 production. These are money-losing three-way collars right now. We will see on May 6 whether Marathon is still holding these unsuccessful contracts.
Swaps and Other Strategies
This is not an exhaustive look at the company’s total hedging strategy. Marathon Oil has “swap” contracts where it will receive $30.73 for 60,000 BPD of its oil production in Q2. In other words, it swaps out its production of 60,000 BPD for a fixed price of $30.73 BPD. So far, that price is much higher than the spot price of crude oil.
This swap hedging strategy will likely be very profitable for Marathon – at least while crude prices stay this low. But the company did not have any of these swaps in Q1. And we don’t know if Marathon had any more of these swaps after April 8 for Q2 through Q4.
All in all, Marathon had very poor hedging strategies in Q1 and we should expect a good deal of losses. But the strategies for Q2 look profitable. I am not inclined to believe that its Q3 and Q4 strategies are going to be profitable right now. On May 6, we will learn more about how Marathon is doing in this regard.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide, which you can review here.
