Why Diamondback Energy Is One of the Best Upstream Stocks
Diamondback Energy’s commodity hedging
We discussed Diamondback Energy’s (FANG) production and capex guidance in the previous part of this series. Here, we will discuss the company’s commodity derivative contracts and their effects. As of June 30, 2015, FANG had in aggregate ~1.93 million barrels of its crude oil production hedged. Most of the hedges expire in December this year, while 91 thousand barrels of oil are hedged until February next year.
The aggregate production hedged for 2H15 represents ~44% of Diamondback Energy’s 1H15 production. At the beginning of the year, ~10,700 barrels per day of FANG’s estimated 2015 production were hedged with a combination of Brent, WTI, and LLS fixed price swaps at an average price of $88.14 per barrel. This would amount to approximately 33% of the company’s 2015 production guidance.
Explaining Diamondback Energy’s derivative contracts
Hedges or derivative contracts reduce the exposure to financial loss resulting from less-than-expected production, or any adverse movement in crude oil prices. Diamondback Energy’s crude oil hedges are in the form of fixed price swaps. FANG receives a fixed price per barrel of oil and pays a floating market price per barrel of oil to the counterparty in the swap. Floating prices are based on West Texas Intermediate (or WTI) crude price, Argus Louisiana light sweet pricing, and Brent crude price (for international) under these swap contracts. In a swap contract, the fixed and floating payments offset each other, and the net amount is credited or debited from the counterparty with which the contract was signed.
Diamondback Energy’s commodity price exposure
As all of Diamondback Energy’s hedges expire after February 2016, it will be exposed to crude oil price movement if it does not put in more hedges. Crude oil price has plummeted from ~$110 per barrel in June 2014 to ~$40 per barrel now. So, it is unlikely that the company can strike a deal at a price as high as $87 per barrel now, as it was able to do at the end of 2014. This may significantly reduce FANG’s revenues, and can also severely affect its net income in the future.
In 2Q15, Diamondback Energy, which makes up 1.4% of the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), recorded a $19 million loss on derivative instruments. EOG Resources (EOG), a much larger peer by market capitalization compared to FANG, recorded a $48.5 million loss on mark-to-market commodity contracts in 2Q15. Parsley Energy (PE) recorded a $17.7 million loss on 2Q15 derivatives contracts. Gulfport Energy (GPOR) recorded a $34 million net derivatives loss in 2Q15.