Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to a variety of market risks, including commodity price risk, interest rate risk, counterparty and customer risk and inflation risk. We address these risks through a program of risk management, including the use of derivative instruments.
The primary objective of the following information is to provide forward-looking quantitative and qualitative information about our potential exposure to market risk. The term “market risk” refers to the risk of loss arising from adverse changes in crude oil, NGL and natural gas prices and interest rates. The disclosures are not meant to be precise indicators of expected future losses, but rather indicators of reasonably possible losses. This forward-looking information provides indicators of how we view and manage our ongoing market risk exposures. All of our market risk sensitive instruments were entered into for hedging purposes, rather than for speculative trading.
Commodity price exposure risk. We are exposed to market risk as the prices of crude oil, NGLs and natural gas fluctuate as a result of a variety of factors, including changes in supply and demand and the macroeconomic environment, all of which are typically beyond our control. The markets for crude oil, NGLs and natural gas have been volatile, especially over the last several years and these prices will likely continue to be volatile in the future. To partially reduce price risk caused by these market fluctuations, we have entered into derivative instruments in the past and expect to enter into derivative instruments in the future to cover a significant portion of our future production. In addition, entering into derivative instruments could limit the benefit we would receive from increases in the prices for crude oil, NGLs and natural gas. We recognize all derivative instruments at fair value. The credit standing of our counterparties is analyzed and factored into the fair value amounts recognized on our Consolidated Balance Sheets. Derivative assets and liabilities arising from our derivative contracts with the same counterparty are also reported on a net basis, as all counterparty contracts provide for net settlement. See “Item 8. Financial Statements and Supplementary Data—Note 9— Derivative Instruments” and “Note 8—Fair Value Measurements” for additional information regarding our commodity derivative contracts.
The fair value of our unrealized crude oil derivative positions at December 31, 2022 was a net liability position of $291.9 million. A 10% increase in crude oil prices would increase the fair value of this unrealized derivative liability position by approximately $102.4 million, while a 10% decrease in crude oil prices would decrease the fair value of this unrealized derivative liability position by approximately $99.2 million. The fair value of our unrealized NGL derivative positions at December 31, 2022 was a net asset of $2.8 million. A 10% increase or decrease in NGL prices would decrease or increase, respectively, the fair value of this unrealized derivative asset position by approximately $0.6 million. The fair value of our unrealized natural gas derivative positions at December 31, 2022 was a net liability of $16.0 million. A 10% increase in natural gas prices would increase the fair value of this unrealized derivative liability position by approximately $2.2 million, while a 10% decrease in natural gas prices would decrease the fair value of this unrealized derivative liability position by approximately $5.8 million. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Recent Developments—Market Conditions and Commodity Prices,” for further discussion on the commodity price environment. See “Item 8. Financial Statements and Supplementary Data—Note 9—Derivative Instruments” for additional information regarding our derivative instruments.
In addition, in connection with the sale of our upstream assets in the Permian Basin in June 2021, we are entitled to receive up to three earn-out payments of $25.0 million per year for each of 2023, 2024 and 2025 if the average daily settlement price of NYMEX WTI crude oil exceeds $60 per barrel for such year. If the NYMEX WTI crude oil price for calendar year 2023 or 2024 is less than $45 per barrel, then each calendar year thereafter our right to receive any remaining earn-out payments is terminated. As of December 31, 2022, the fair value of this contingent consideration was $60.9 million. See “Item 8. Financial Statements and Supplementary Data—Note 9—Derivative Instruments” for additional information.
Interest rate risk. At December 31, 2022, we had $400.0 million of senior unsecured notes at a fixed cash interest rate of 6.375% per annum.
At December 31, 2022, we had no borrowings and $6.4 million of outstanding letters of credit issued under the Credit Facility, which were subject to varying rates of interest based on (i) the total outstanding borrowings (including the value of all outstanding letters of credit) in relation to the borrowing base and (ii) whether the loan is a Term SOFR Loan or an ABR Loan (each as defined in the amended and restated credit agreement). See “Item 8. Financial Statements and Supplementary Data—Note 15—Long-Term Debt” for additional information on the interest incurred on the Credit Facility.
We do not currently, but may in the future, utilize interest rate derivatives to mitigate interest rate exposure in an attempt to reduce interest rate expense related to debt issued under the Credit Facility. Interest rate derivatives would be used solely to modify interest rate exposure and not to modify the overall leverage of the debt portfolio.
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Counterparty and customer credit risk. Joint interest receivables arise from billing entities which own partial interest in the wells we operate. These entities participate in our wells primarily based on their ownership in leases on which we choose to drill. We have limited ability to control participation in our wells. For the year ended December 31, 2022, our credit losses on joint interest receivables were immaterial. We are also subject to credit risk due to concentration of our crude oil, NGL and natural gas receivables with several significant customers. The inability or failure of our significant customers to meet their obligations to us, or their insolvency or liquidation, may adversely affect our financial position and related financial results.
We monitor our exposure to counterparties on crude oil, NGL and natural gas sales primarily by reviewing credit ratings, financial statements and payment history. We extend credit terms based on our evaluation of each counterparty’s credit worthiness. We have not generally required our counterparties to provide collateral to secure crude oil, NGL and natural gas sales receivables owed to us. Historically, our credit losses on crude oil, NGL and natural gas sales receivables have been immaterial.
In addition, our crude oil, NGL and natural gas derivative arrangements expose us to credit risk in the event of nonperformance by counterparties. However, in order to mitigate the risk of nonperformance, we only enter into derivative contracts with counterparties that are high credit-quality financial institutions. All of the counterparties on our derivative instruments currently in place are lenders under the Credit Facility with investment grade ratings. We are likely to enter into any future derivative instruments with these or other lenders under the Credit Facility, which also carry investment grade ratings. This risk is also managed by spreading our derivative exposure across several institutions and limiting the volumes placed under individual contracts. Furthermore, the agreements with each of the counterparties on our derivative instruments contain netting provisions. As a result of these netting provisions, our maximum amount of loss due to credit risk is limited to the net amounts due to and from the counterparties under the derivative contracts.
Inflation risks. Similar to other companies in our industry, we have experienced an increase in the costs of labor, materials and services during 2022 due to a combination of factors, including: (i) global supply chain disruptions resulting in limited availability of certain materials and equipment (including drill pipe, casing and tubing), (ii) increased demand for fuel and steel, (iii) increased demand for services coupled with a limited availability of service providers and (iv) labor shortages. The combination of these factors increased our operating costs and capital expenditures in 2022, which in turn negatively impacted our operating results and cash flows. We believe that these inflationary pressures could continue in 2023 for certain costs, such as the costs of workover rigs, even if inflationary pressures were to level-off for certain other costs, such as steel and tubular goods. We seek to mitigate these inflationary impacts by reviewing our pricing agreements on a regular basis and entering into agreements with our service providers to manage costs and availability of certain services that are utilized in our operations. It is difficult to predict whether such inflationary pressures will have a materially negative impact to our overall financial and operating results in 2023; however, such inflationary pressures are not expected to materially impact our overall liquidity position, cash requirements or financial position, or the ability to conduct our day-to-day drilling, completion and production activities. See “Part I, Item 1A.—Risk Factors—Our profitability may be negatively impacted by inflation in the cost of labor, materials and services and general economic, business or industry conditions” for additional information.
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