Publications: Notes at the Margin

Hedging: Fracking CEOs Pay for Their Stupidity (August 2, 2021)


Scott Sheffield and Harold Hamm, CEOs of Pioneer Natural Resources and Continental Resources, are heralded in some quarters as business geniuses who have built large, profitable independent oil producers. In our view, they do not deserve the acclaim. On the contrary, current or future academics will likely rank them, along with many other independent oil company executives, among the stupidest and unenlightened of such individuals in company with Antonio Pérez, who led Eastman Kodak into bankruptcy.


We criticize the CEOs of the independent oil companies, commonly known as the “frackers,” because almost all of them have reported or will soon report substantial “losses” from their hedging activities. This development has led many observers to malign the firms for their choosing to hedge.


Never has hedging been so roundly lambasted. The condemnation is unfair. The carping analysts and print and TV business reporters are sadly uninformed as to the economics of hedging. Their ignorance threatens to force these companies to abandon hedging and, as a result, expose their investors to Eastman Kodak’s fate—bankruptcy—should prices collapse.


The bankruptcies, should they come, will only strengthen the hand of the largest oil-exporting countries and multinational oil companies. Indeed, the most rational economic strategy for those nations and firms would be to capitalize on the frackers’ lack of hedging for 2022 by staging another price war early that year, keeping prices low enough to really squeeze the independents.


US independent firms and countries that have chosen not to hedge going forward repeat the mistake made by other commodity producers who swung from hedging one year to not hedging the next. Invariably, such firms and countries get “wrong-footed” and lose by trying to anticipate the markets.


The fracking executives do not seem to read history. We suspect they spend far too much time on golf courses or their ranches.


As we explain below, there are several ways to hedge. Traditionally, most US oil producers have chosen the least expensive method, purchasing puts to protect against price declines while selling calls, giving up potential profits. They have done this because the approach costs nothing at the time the hedge is set. The theory is that the companies would use the money saved to drill—except that firms like Pioneer have chosen not to drill, essentially playing their shareholders for suckers.


The country of Mexico has chosen a different hedging method, paying billions out of pocket for puts. This action has protected the government from revenue declines, particularly in 2020, while allowing the nation to profit when prices rise. The Mexican system, set up by a finance minister who happened to be an MIT-trained economist, has provided Mexico with a steady oil cash flow for more than three decades. Mexico, then, has established the gold standard for hedging, as we explain below. In contrast, Pioneer and Continental have, one could say, set the “lead standard.”


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