Less than two months ago, after the Algiers meeting – but before the Vienna OPEC summit, when speculation was rife that the cartel would be unable to reach a deal to cut production – we reported:
“While OPEC has been busy desperately jawboning oil higher, U.S. producers have been worried about oil’s reacquaintance with gravity. As a result, as the EIA reports, the amount of WTI short positions held be producers and merchants is just shy of a decade high.”
So now that the OPEC deal is done – if only on paper, with formal implementation and compliance checks still up in the air until February 2017 at the earliest – have producers changed their tune?
One look at the changes to the oil strip reveals that the answer is no, and as Bloomberg reports, “U.S. shale oil companies are using the post-OPEC rally to hedge their oil price risk for next year and 2018 above $50 a barrel, bankers, merchants and brokers said, pushing the forward oil curve upside down.”
This rush to hedge could lead to a materialization of the biggest risk – and threat – to the OPEC deal: much higher U.S. oil production in 2017, offsetting the first OPEC production output cut in eight years. As such, the producer group could end throwing a life-line to a sector it once tried to crush.
Confirming that while speculators, many of whom have been squeezed as a result of a recent surge in short bets, have thrown in the towel on lower prices for the time being, producers are once again skeptical that the higher prices will prove sustainable: “Right after OPEC, U.S. producers were very active hedging,” said Ben Freeman, founder of HudsonField LLC, a boutique oil merchant with offices in New York and Houston. “We are going to see a significant amount of producer hedging at this levels.”
The hedging pressure triggered violent movements across the price curve. As shale firms sold oil for delivery next year and early 2018 the curve has notably flattened, leading to the first backwardation since 2014, as we observed last week.
Sure enough, as Bloomberg highlights today, “WTI for delivery in December 2017 is now more expensive than in June 2018 – a condition known as backwardation. A week ago, the forward curve was in the opposite shape, known as contango.”
“The curve is screaming producer hedging,” said Adam Ritchie, founder of consultant AR Oil Consulting and a former trading executive at Caltex Australia LTD. and Royal Dutch Shell PLC.
Another take came from Harry Tchilinguirian, head of commodity strategy at BNP, who said that, “The longer dated flattening in the futures curve does indeed reflect to a large extent increased producers activity, hedging on the back of the pop up in spot prices that followed the announcement of an output cut by OPEC.”
In the past year we have shown on various occasions that $50 seems to be the psychological level above which shale producers come out in droves to hedge future price increases. This time is no different:
“The latest surge in prices extends U.S. shale drillers’ pattern of adding hedges when crude rises into the mid-$50s. Pioneer Natural Resources Inc., for example, said in early November that it increased its hedges for next year to 75 percent of production from 50 percent. In the third quarter, Devon Energy Corp. more than quadrupled its 2017 positions from the prior three months.”
While the public won’t know for certain what current hedge positions are – U.S. shale companies and independent E&P companies usually reveal their level of hedging with a quarter delay – Bloomberg notes that anecdotal pricing activity already suggests their presence in the market. U.S.-based oil bankers and brokers also said they handled significant volumes after OPEC agreed to cut production. As it further adds, a record 580,000 crude options contracts traded on the New York Mercantile Exchange that day, while the number of puts hit the highest since 2012.
“As the oil curve flipped, inter-month spreads, which move about 5 to 10 cents a day in normal times, swung eight times as much. The spread between December 2017 and December 2018 – a popular trade known in the industry as “Dec-Red-Dec” – jumped from minus $1.35 a barrel early on Wednesday, before OPEC announced the deal, to plus 49 cents on Friday.”
Finally, as noted above, a key factor pressuring forwards oil prices is doubt about whether OPEC and Russia will continue to curb supply when the deal ends in six months.
“Two things might be priced in this change — the first one is that shale producers are hedging and the second one is that the deal is for six months and then no one knows what’s going to happen,” said Tamas Varga, analyst at brokerage PVM Oil Associates LTD.
So while the OPEC deal continues to flush out the weak spec shorts, who continue to cover into this major oil rally, which has jumped 12% since last week and the biggest weekly gain in six years – US shale producers are once again far more skeptical about future price gains, and are not only hedging at a torrid pace, but telegraph that the rally has peaked. After all, who better know the all-in breakeven costs of oil production than the producers themselves.