For Oil’s Future, Peer Through the Hedges

In oil, like life, the secret to happiness is to lower your expectations. That isn’t just a piece of homespun, nihilist wisdom. It’s what’s happening beneath the surface of the oil market.

Hedging is how exploration and production companies manage their market risk. Locking in a price for future output — by, for example, selling oil futures — provides certainty on cash flow. This not only helps management sleep at night. More importantly — in an industry as profligate as this one — it helps their bankers and shareholders rest easier, too; maybe even dream a little.

So data on hedging by producers provides some insight on where their head is at. And, fortunately enough, Matt Hagerty and Peter Pulikkan of Bloomberg Intelligence have just released a detailed survey of 37 E&P companies pumping an estimated 4.2 million barrels a day. Their data show E&P companies getting by with less these days.

First, a little history. The chart below shows the net short position of swap dealers in Nymex crude oil futures and options. This is a proxy for hedging activity by E&P companies (which generally use swaps dealers to establish their hedging positions). The lower the number, the more oil sold short, or hedged. I’ve marked some periods to show what oil prices and rig counts were like at those times:

There are three phases there:

• 2007 to 2008: Peak-oil supply thinking, implying prices were only going up, was all the rage. Meanwhile, fracking was focused on natural gas. So industry hedging of oil was minimal.
• 2009 to 2014: Oil prices crash and rebound while gas prices crash and don’t. E&P companies switch their focus to fracking for oil, so the oil-rig count soars and so does hedging to help finance fracking.
• Late 2014 to present: Oil prices crash and so does drilling. OPEC-led efforts to support prices stabilize the market, leading E&P companies to resume drilling, and hedging to help fund it.

The real plot twist there concerns price.

During the first shale wave that crested and broke in 2014, the 12-months forward oil “strip” (or average price) was bobbing around at $100 a barrel, a very attractive level at which to sell future production. Since early 2016, as E&P firms have resumed drilling and hedging again, the strip has been more like $50 to $55.

I wrote here about how $50 seemed to have become a threshold for E&P companies either cranking up or turning down, due in part to productivity gains made under pressure. Bloomberg Intelligence’s hedging survey strengthens the point. Out of their 37 companies, 32 have hedged some of their anticipated oil production for 2017. Overall, 43 percent of that output is hedged at an average price of $50 and change a barrel.

In the Permian shale basin, the engine of U.S. production growth, a dozen E&P companies  in the survey have hedged an even higher share of this year’s expected output at even lower prices: 64 percent at a weighted average of $49.43 a barrel. One or two bigger producers, such as Concho Resources Inc., actually skew that average higher; the median price is less than $47 a barrel.

It isn’t as if these companies like getting less than $50 a barrel, or are making a prediction on prices . It is just that, for the purposes of funding their businesses — including growth plans — it is a price they can live with.

This is why, in a slew of reports released this week by OPEC, the Energy Information Administration and the International Energy Agency, estimates of U.S. oil production growth for 2017 were all revised higher. This, along with OPEC members maxing out production ahead of their cuts and (something to watch) softer demand than expected, mean the oil market has proven slow to tighten.

All of which leaves OPEC and its partners in a bind as they head towards next month’s meeting. Even the strongest in their ranks, such as Saudi Arabia, can only stomach $50 a barrel for so long (while basket cases such as Venezuela face catastrophe). It is pretty much a given that the cuts will be extended at the meeting in order to drain more oil from the glut of inventories built up in the last few years.

Yet this raises a thorny problem.

As of now, only 21 of the 37 companies in the Bloomberg Intelligence survey have hedged any of their anticipated oil production for 2018, and these hedges cover less than 10 percent of it. The Permian set have hedged more, but still only 22 percent. The current futures strip for 2018 is $54 and change, around where futures prices for the rest of the decade have stabilized since early 2016 even as near-month prices have bobbed up and down. While futures prices are not predictions, the stability of those longer-term futures suggest that U.S. shale producers’ costs, as reflected in their hedging programs, are expected to be price setters in the oil market in the next few years.

In other words, if shale producers can live with oil at $50 or thereabouts, then others will have to adapt themselves to that level. Moreover, if OPEC “succeeds” in pushing up price expectations with extended supply cuts, Permian producers will thank them in the only way they know how. Namely, by laying on more hedges for 2018, using the cash to produce more oil — and thereby pulling those prices back down.

bloomberg