With all that is going on in Iraq and Iran over the weekend, it would be hard to focus on anything else but that’s exactly what we are going to do (for more on Iran, listen to the 10 minute “Hottakeover Your Commute” podcast, released every Sunday).

Hedging!  The boring topic that no management team wants to talk about for fear of taking away levered upside. But first, we must lay out some assumptions:

2020 budget oil price: $55;

Royalties: 25%;

Sev/Ad Val: 5%;

Opex/Trans: $6

G&A: $2.50

EBITDA of $30/bbl. 

For simplicity, we are going to assume “ReallyWalkingTheChapter11LineCo” produces 1 bbl of oil per year (LineCo for short).

So far so good?

On Thursday, through absolutely no decisions of management teams, an airstrike in Iraq increased the average oil price to $61.40 for 2020 (as of Sunday evening), meaning $4.50/bbl in extra cash flow (revenue less royalties and severance/ad val), or 15% of the budget price.

Now let’s look at debt.  LineCo has 2.7x Debt / EBITDA which is $81 of debt (2.7x $30).

For argument’s sake, LineCo set their 2020 capital at $26 and manage to keep production flat: that’s $4 in free EBITDA! But we know from the Leverage series, EBITDA isn’t cash… and the interest on the $81 of debt is $4.86, so debt actually goes up at the end of the year. Scenario time… get out Aries (just kidding, nobody does that! Management just adds a “wedge” to fix things).

Wedge aside, the two options are:

1) Cut your capital program, see production decline and generate less than $30 in EBITDA. Debt/ EBITDA goes up and covenants on the debt fail leading to Chapter 11 and equity value going to 0. Since your options are in equity… that’s a non starter.

2) Raise your capex… actually, no.  We aren’t even going to talk about this… Please Lord, don’t let anyone be this stupid in 2020.

So, only one option and it leads to a bigger problem. If only there was a riskless way to fix things?  Wait? What’s that you say? EDGE! LEDGE? Oh….HEDGE!!!

The extra $4.50/bbl generates more than double the original free EBITDA! That means LineCo can use it to pay down the principal of the debt. This, in turn will put a squeeze on short sellers and equity values rise because of decreased bankruptcy risk. Employees and management will then be paid big bonuses for an event they had no control over but will enable them to sell the company (for equity) to another company with a lower D/EBITDA, driving the combined equity goes even higher. Everyone retires and lives happily ever after.

That’s what I’d do… what’s the over/under on anybody else?