On shale hedges and oil prices

Catching up on the oil news of late....

Several recent pieces on the impact of shale producers on prices. Liam Denning's article from Bloomberg.com looks at the use of hedges by shale producers and how it's restraining OPEC's attempt to raise prices (as I've mentioned in quite a few of my previous posts).  Denning provides data that essentially confirms how shale producers use hedges to lock in prices a year out when WTI oil rises above $50 per barrel, which then puts a cap on any price run up. His conclusion:

"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."

This shouldn't be news to anyone who has been following my blog.

The data provided by Denning provides some interesting information concerning the history of oil prices and the impact of financial players.  In particular, there is a figure that shows the net shorts of the swaps positions (includes options and futures) in NYMEX oil.  According to Denning, "This is a proxy for hedging activity by E&P [exploration and production] companies (which generally use swaps dealers to establish their hedging positions). The lower the number, the more oil sold short, or hedged." His explanation is consistent with what former Goldman Sachs COO [and current chief economic adviser to Trump] Gary Cohn stated about the creation of Commodity Index Funds (CIFs):

"We had clients that wanted to sell future production forward. So we had many clients that wanted to go drill oil wells, but they needed some predictability of the price of oil they were going to receive out of the well to go borrow money. They tried to enter the market and sell oil. There was no natural long in the market. The consumers are so fragmented that they don't amalgamate to a big enough position. So we actually, as a firm, came up with the idea in the early 1990s to create a long only, static investor in commodity markets. We created the commodity index where we could allow people that were willing to commit large pools of capital into the market for a very long period of time to facilitate the actual producers and allow them to be able to hedge their production forward to increase their production."

Goldman Sachs and other Wall Street banks sold CIF swaps to pension funds as a way to invest in commodities long term; however, the banks (swap dealers) then had to buy contracts on the exchange to hedge their payouts on the CIF swaps they sold. These long-term commodity investments held by pension funds allowed oil exploration firms to lock in prices over a longer time horizon to cover their investments, just as Cohn argued above.  However, the flexibility of the shale producers is changing the nature of hedging as discussed in this FT.com article:

"The number of outstanding oil contracts for delivery years into the future has plummeted on the New York Mercantile Exchange. Since 2012 open interest has declined by more than 75 per cent for benchmark West Texas Intermediate crude expiring in three or four years’ time. During the same period the entire WTI market has expanded by 40 per cent."

Shale oil producers are able to rapidly ramp up production with new rigs, and costs are sufficiently low enough that they are profitable whenever the futures price exceeds $50.  In addition, as the data show, long term hedges (3 and 4 years out) have declined significantly yet overall hedging is 40% higher.  The bottom line is the shale producers are making it nearly impossible for OPEC to raise prices through production cuts because of their ability to rapidly open new rigs, lock in prices a year out, and it is profitable for them to do so when the price of WTI exceeds $50.

The latest development, according to this Bloomberg piece, is that Hedge Funds have lost patience and have dramatically reduced their long bets on crude. As I have recently argued, the banks have been preaching patience to the Hedgies, and even though US inventories have declined the past few weeks, they simply won't stand by any longer and lose money:

Investors had been expecting prices to rise to $55 or $60 a barrel in light of the OPEC deal and prices never reached that level, Tariq Zahir, a New York-based commodity fund manager at Tyche Capital Advisors LLC, said by telephone. “You started the year with longs. They’re giving up on the trade to a certain point.”

If oil inventories continue to decline, then I am sure the Hedge Funds will be tempted back in; however, to reiterate my argument once again, prices will rise too high, too fast which will both raise supply through the shale producers' reactions and curtail demand. Oil prices will certainly stay in the range of $40 to $60 for the rest of the year.