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Page added on April 15, 2017

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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:

A Short History
E&P firms boosted hedging activity during the shale-oil boom from 2011 through 2014; pulled back in the crash; and are back to hedging again
Source: Bloomberg
Note: Data show net position of swap dealers in Nymex crude oil futures and options. Oil “strip” is average futures price for the following 12 months in dollars per barrel.

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.

More For Less
Permian-focused E&P companies have hedged a lot of their expected oil production for 2017 — and at less than $50 a barrel, on average
Source: Bloomberg Intelligence

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.

Fixed Horizon
While front-month oil futures have whipped around, stability for longer-term ones has shifted from a level around $85 to around $50-$55 a barrel
Source: Bloomberg
Note: Nymex crude oil futures prices. “Long-range average” represents average price for futures covering 2018 through 2020.

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.


7 Comments on "For Oil’s Future, Peer Through the Hedges"

  1. rockman on Sat, 15th Apr 2017 8:46 am 

    “…U.S. shale producers’ costs…are expected to be price setters in the oil market in the next few years.” The cost to develop oil/NG production never has and never will dictate the price those fossil fuels sell for. It’s the price of oil/NG that determines how much capex companies spend developing those commodities.

    Some will argue this isn’t how the dynamic functions. In that case they must believe oil fell from $90+/bbl to less then $50/bbl because it suddenly became cheaper to drill/frac shale wells, right? Isn’t that what the article just claimed: “…shale producers’ costs…are expected to be price setters…”?

    Always amazing to see so many unable to understand a rather simple cause/effect dynamic.

  2. Plantagenet on Sat, 15th Apr 2017 11:18 am 

    There are a thousand factors that influence the price of oil but the most fundamental controlling factor is still the law of supply and demand.

    When the oil glut started the price of oil collapsed. Now that OPEC is voluntarily restraining production, the price of oil has crept up a bit. Its simple.


  3. GregT on Sat, 15th Apr 2017 11:34 am 

    “When the oil glut started the price of oil collapsed.”

    To prices twice what they were before.

    If you can’t dazzle them with brilliance, baffle them with bullshit.

  4. BobInget on Sat, 15th Apr 2017 12:01 pm 

    For years, Plantagenet ended all of his posts fearlessly pegging oil in glut. So much so, it became annoying. Well, as it turns out he is right and I was wrong. Not that either of us had a scintilla of effect on
    anyone’s decisions.

    Moving on.

    Publicly owned majors, in order to keep paying dividends are busy selling off longer lasting oil sands properties.
    Several deep water oil service companies are seriously flirting with bankruptcy. (and say so)
    The North Sea,. GOM, in decline.
    Mexico, down again over 10%.
    Canadian oil companies being treated as contaminated. Some for buying oil sands from US majors, others for not.
    Nevertheless, a shale well needs four to six miles of drilling, 100,000 feet of pipe, a million or two tons of silica sand, special ‘rigs’ and most of all, willing investors..

    Once again the smartest MEN in the room offed their easiest to sell investments and kept the worst.

    In case you missed the point, WTF will Conoco or Chevron or XOM do for future oil? Oh, I know, follow DJT’s advice and just ‘take’ Iraq’s or Iran’s oil.

    I’m not a BOT, are you?

  5. twocats on Sat, 15th Apr 2017 12:21 pm 

    its looking more and more and more and more like oil prices have a lot of things preventing them from going up, from demand destruction, to recessions, to hedging, and on and on.

    this will mean that any projects that require $75+ barrel to be profitable simply won’t be developed. It will also limit exploration.

    which means we will slow burn on this fracking bullshit and legacy wells until the candle flickers out.

    prices never going above a certain range, prices never going above a certain range, where have I heard that theory before, it seems like I’ve heard it before.

    sounds a lot like shortonoil and Hills Group.

  6. twocats on Sat, 15th Apr 2017 12:35 pm 

    as for plant’s sad oil-glut supply/demand endless repetition, its barely worth debating the argument is so stupid.

    I bet in the past 10 years there’s a much stronger correlation between price and central bank printing than anything having to do with supply and demand. the printing presses cooled a bit in 2014, but the ECB and Japan are currently putting 180 billion a MONTH into the global economy. I’d put a little of that into oil if I were directing asset allocations.

    Asset inflation and the fact that they are pushing on a string in terms of economic output are the only things keeping the floodgates closed. But until you have “rent-riots” in places like seattle, new york, and san francisco, the game will continue.

  7. Joe Clarkson on Sat, 15th Apr 2017 5:57 pm 

    BobInget said “Nevertheless, a shale well needs four to six miles of drilling, 100,000 feet of pipe, a million or two tons of silica sand, special ‘rigs’ and most of all, willing investors.”

    Lateral lengths are now 10,000 feet, to 20,000 feet at the very most, with proppant use rising toward one ton per lineal foot. Most wells use less than that. “A million or two tons of sand” is off by a factor of 100 or so.

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