OPEC Deal Spurs Oil Futures Hedging

U.S. shale oil companies use post-OPEC rally to hedge oil price risk for 2017 and 2018

The Organization of Petroleum Exporting Countries (OPEC) achieved a major milestone when it closed its first deal in eight years to cut oil production and normalize record global oil inventories on November 30th, 2016. Following this event, benchmark oil prices gained as much as 10% to breach the $50 a barrel barrier, spurring U.S. shale oil companies to hedge their oil price risk for 2017 and 2018, as reported by Bloomberg on December 05th, 2016.

US shale companies are making use of higher crude oil prices to lock-in cash flows for 2017. The rush in hedging activity by locking in future cash flows and sales prices could translate into higher US oil production in 2017, thereby offsetting the impact of the first output cut by the OPEC. US independent oil companies have only hedged 16% of their price exposure for 2017, compared with 39% for the rest of 2016. As a result, the increased hedging activity has pushed the forward oil curve upside down.

As shale firms sold oil for delivery in 2017 and early 2018, the shape of the curve flattened. West Texas Intermediate crude for delivery in December 2017 is now more expensive than in June 2018, a condition known as backwardation. This is in comparison to the forward curve being in the opposite shape, known as contango, in the prior week when hedging activity was not so pronounced. The longer dated flattening in the futures curve reflects increased producers’ activity, hedging on the back of higher spot prices that followed the announcement of an output cut by OPEC.

Source: Bloomberg

Shale companies lock in higher prices

Warwick Energy Investment Group, a privately held owner of stakes in thousands of US wells, added hedges on December 1st and 2nd, 2016, immediately after the OPEC announced its production cuts. The company has over 200 wells currently drilling and has locked in a 20%-plus internal rate of returns.

The latest surge in hedging activity underscores the pattern generally witnessed among US shale drillers when crude rises into the mid-$50s. Pioneer Natural Resources Co. said in early November 2016 that it increased its hedges for next year to 75% of production from 50%. In Q3 FY16, Devon Energy Corp. more than quadrupled its 2017 positions from the prior three months.

Record for crude options contracts

US shale companies and other independent exploration and production companies usually reveal their level of hedging with a quarter delay. Nonetheless, anecdotal pricing activity already suggests their presence in the market. US-based oil bankers and brokers also said they handled significant volumes after OPEC agreed to cut production. As such, a record 580,000 crude options contracts traded on the New York Mercantile Exchange on December 01st, 2016, while the number of puts used by producers to guarantee a minimum price hit the highest since 2012.

Crude oil spread jumps

As the oil curve flipped, inter-month spreads, which move about 5 to 10 cents a day in normal times, jumped eight times as much. The spread between December 2017 and December 2018 jumped from minus $1.35 a barrel early on Wednesday, November 30th, 2016, before OPEC announced the deal, to plus $0.49 on Friday, December 02nd, 2016. Another factor keeping pressure on forwards prices is doubt about whether OPEC and Russia will continue to curb supply when the deal ends in six months.

Source: Bloomberg
Source: Bloomberg

While OPEC has struck a deal to reduce output by about 1.2 million barrels a day from January 2017, fulfilling a plan in September 2016 to cut its production to 32.5 million barrels, economists have warned that crude oil prices could recede over the next few months as other producers, especially US shale drillers, are standing ready to fill the supply gap. US crude production has already risen by more than 3% in 2016 to 8.7 million bpd, as its drillers have slashed costs in an effort to compete in a lower price environment.

However, the strength of the deal will depend on whether all parties deliver on their commitment. Saudi Arabia and its Gulf allies, the U.A.E. and Kuwait, have traditionally stuck to their cuts, but some others have not, particularly when prices are low. Any doubt in the market could once again see prices come under pressure. OPEC will meet again on May 25th, 2017, at which point it intends to extend the cuts by another six months.

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