Oil prices have been hyper-volatile this year. Brent crude, the global oil benchmark, started this year at around $60 a barrel. It doubled at one point before trending back down below $100 a barrel more recently.
Many oil companies use hedges to help mitigate the impact of oil price volatility on their earnings. However, oil price hedges acted as a headwind to oil industry profits during the first quarter, including for Occidental Petroleum (OXY 2.97%). As a result, Occidental doesn't plan to add any more hedges this year. Here's what it means for investors in the oil stock.
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The hidden cost of costless collars
Occidental Petroleum, like most oil companies, initially saw downside risks to crude oil prices this year. The industry expected a supply glut due to surging production and modest demand growth. As a result, many companies used derivatives to hedge some of their production to mute the sting of lower prices.
Occidental Petroleum's CFO, Sunil Mathew, discussed the company's hedging strategy on its recent first-quarter call. The CFO stated that the company placed a "modest amount of oil hedges using costless collars" before the war started in February. Mathew noted that "at that time, we saw increased downside oil price risk," leading the company to hedge "100,000 barrels of oil per day from March through December 2026."
The company hedged these volumes at a floor price of $55 a barrel and a ceiling of $76 per barrel. While the company didn't incur a cost to set up these costless collar hedges, it's now paying a price as crude oil has surged past the ceiling. They require the company to sell 100,000 barrels per day at the ceiling price of $76 a barrel through the end of the year. While that's a small percentage of its production (Occidental produced 617,000 barrels of oil per day in the first quarter), it booked a derivative loss of $339 million in the period.
Hedges can hurt during good times
Occidental wasn't the only oil company to have its hedging strategy work against it in the first quarter. ExxonMobil's (XOM 1.39%) earnings fell from $7.3 billion in the fourth quarter to $4.9 billion in the first quarter, even though oil prices and refining margins were much higher this year. The culprit was a timing mismatch with its derivatives. While Exxon produced the volumes in the first quarter, it won't deliver them to customers until later periods. However, Exxon had to adjust the value of its derivatives for the current quarter, resulting in an unfavorable impact of $3.9 billion. Without that impact, Exxon's earnings would have been $8.8 billion in the first quarter. Fellow oil giant Chevron experienced a similar impact from a timing mismatch.
Occidental doesn't want its hedging strategy to remain a headwind in the current environment. As a result, it has already stopped adding new hedges at the $76-a-barrel ceiling and doesn't intend to add any more this year. That strategy could prove wise if oil prices continue to rise, since it won't be locking in additional barrels at lower prices. However, Occidental also risks oil prices declining sharply if there's a peace deal between the U.S. and Iran that reopens the Strait of Hormuz. It might regret not locking in today's higher prices.
A smart strategy, even if it didn't work
Occidental Petroleum's decision to hedge a portion of its oil at a $76 a barrel ceiling made a lot of sense earlier this year. While the strategy backfired as crude blew through that ceiling, it would have protected some of the company's cash flow if oil prices plunged below $55. Likewise, its current decision not to hedge oil makes sense, given the expectation that crude prices will remain elevated this year. Occidental is trying to make the most informed decisions based on current market conditions, which can change on a dime. Investors should appreciate the company's adaptability, which suggests that management is doing its best to mitigate risks.
