Shale Hedges Threaten Oil Rally

Surge in hedging puts downward pressure on the oil futures curve.

By Nick Cunningham,

The 20 percent increase in oil prices since September led to a wave of hedging by U.S. shale drillers eager to lock in future production at prices not seen in years. The flip side of that hedging wave is that locking in prices could cut the price rally off at the knees, ensuring that more supply will be forthcoming in the next few quarters.

Shale drillers were hesitant for much of the year, but kicked their hedging programs into high gear after oil prices posted strong gains beginning in September. “The past three months have seen a significant increase in oil hedging, with the volume of new positions more than twice the volume of Q3 hedges that rolled off the books,” Standard Chartered wrote in a recent research note.

The volume of oil hedged for 2018 increased by 29 percent over the past three months. Meanwhile, natural gas prices have barely budged, and the lack of price movement kept gas hedging at a minimum, the bank said.

Interestingly, about 90 percent of the incremental hedging that has occurred in recent months came from just a relatively short list of 20 active companies. Hess Corp. topped the list, adding 115,000 bpd of new hedges for 2018. Pioneer Natural Resources came in a distant second with an additional 59,000 bpd of hedged production for next year.

The wave of hedging has showed up in exchange trade data for WTI. The number of open contracts that have yet to be settled has jumped by nearly a quarter since June, according to Reuters. “The reason is producer hedging in USA as well as the funds all being very bullish. Shale producers will use WTI as a hedging instrument and not Brent,” Oystein Berentsen, managing director for Strong Petroleum in Singapore, told Reuters in an interview earlier this month.

The average 2018 hedge price that these oil drillers secured for their production was $52.15 per barrel, according to Standard Chartered. Typically, a rush of hedging puts downward pressure on the oil futures curve, preventing any further rise in oil prices. But Standard Chartered said that those fears of a hard ceiling on prices are unfounded. “Concerns have been expressed in various media outlets that any oil price rise will be swiftly snuffed out by a wave of hedging from the Permian. We think those concerns are greatly overdone,” the investment bank wrote.

Permian-focused shale companies have hedged about 72 percent of their 2018 production, but Standard Chartered doesn’t see that proportion rising above 80 percent. In other words, the industry is basically finished with 2018 hedges, which means that hedging shouldn’t have much of an impact on prices for next year, while the focus will shift to 2019 output.

Moreover, the futures curves—particularly for Brent—shifted from a state of contango to backwardation along parts of the futures curve. That is, prices are trading at a discount further out into the future compared to right now, which makes it much more difficult for shale drillers to hedge. WTI hasn’t opened up into backwardation just yet, but the contango has narrowed significantly. “The WTI structure has flattened to an almost pancaked contango,” John Driscoll, director of JTD Energy Services, told Reuters two weeks ago. “Contango is a hedger’s best friend so if the market continues to follow Brent into backwardation, hedging will become more challenging.”

Hedging does provide some certainty to shale drillers though, which could allow those with secured hedges to redeploy rigs and accelerate drilling. The U.S. rig count has been falling since August, having shed about 30 rigs over the course of a few months. The past two weeks are an early indication that things could be turning around—for the week ending November 10, the shale industry added nine rigs back into operation. The next week the rig count remained flat. These are some early and tepid signs that the rig count may have bottomed out.

In addition, the rig count has continued to rise in the Permian, where most of the shale action is these days. New hedges could allow Permian producers to continue their drilling efforts, which suggests more production could come online in the months ahead.

OPEC will undoubtedly take this into account when they meet next week. By Nick Cunningham,

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  15 comments for “Shale Hedges Threaten Oil Rally

  1. If I believed that interest rates are permanently low, and that inflation is not going to rise significantly, then I would hedge 100% of oil production. By analogy when market participants “hedged” the equity markets in early 2016, when the hedge came off after the election it was off to the races.
    What’s happening here may be a mirror of those events, with geopolitical instability in the ME, and low oil prices in the US, foreign interests will start buying up US oil reserves, along the lines of Russia buying up Trump votes on FB. The great fallacy in American thinking is that “its all about us..” The election should have been a wake up call.

    • Mell Gibsom says:

      Trump votes bought on FB? Seriously?

      • Jaco says:

        Yep……it’s ridiculous alright.

        I was never going to vote for another D/R establishment candidate again……and Facebook, let alone any Russian participation, had zero to do with it.

        I know many many others felt the same way.

        • J Bank says:

          Common misconception: it’s not about trying to get you to switch your vote, it was about discouraging the opponent’s base’s desire to vote.

  2. Paulo says:

    Always assumptions in these stats.

    The top company on the list is Hess, at 115,000 bpd, then the next at is 59,000 bpd.

    This is in contrast to world wide consumption at 93-94 million bpd. What is total amount hedged? .25 of 1%? When the so-called glut is approx 1% above requirements, the hedged production is hardly a game-changer.

    Furthermore, (and back to assumptions), built into the the current price assumes Saudi Arabia is not in disarry despite the recent wave of arrests. It assumes that there will not be any additional conflict with Iran in the ME, despite all the proxy wars going on. It assumes that shale companies will be able to obtain operational budget financing indefinitely, despite not making any money on actually producing oil and selling it at these prices.

    One stumble/miscalculation in conflict and sabre-rattling by any party currently muscling around the ME these days could push everything into disarray and produce a rapid escalation in oil prices. This is especially true with Iran and Saudi Arabia. I don’t know just who is investing in oil companies these days, but I know I wouldn’t. Being locked in to a hedged price works both ways.

    • Wolf Richter says:

      One: You conflate hedging by one company in the US shale space with global production of oil. There are hundreds of companies in the US shale space. And there are other producers outside the US that are hedging, including the Mexican government, one of the largest.

      Two: prices are set at the margins.

  3. cdr says:

    Oil is now a market, and has been for a couple of years. Previously, it was paper flipping combined with a supply that was conducive to paper flipping. Oil hustlers sound a little like gold permabulls today. Some oil hustlers of old now probably hype driverless cars and battery powered cars. Funny.

    What nobody seems to notice is that equities and debt trading will soon be more like oil of today, as opposed to oil of a few years ago. To the bad, people heavily committed to equities and debt trading today will suffer as prices normalize (harshly). To the good, equities and interest rates will reflect the economy and corporate performance just like long ago. The occasional mania and euphoria will still visit. It just won’t affect all financial markets in lockstep. For the long term after the normalization, equities will even seem like a savings account with interest if a good ETF or mutual fund is involved. Just not today.

    • Jim Graham says:

      “”Oil hustlers sound a little like gold permabulls today. Some oil hustlers of old now probably hype driverless cars and battery powered cars.””

      Or cryptocurrency???


  4. rj says:

    Gold permabulls. Like Central Banks?

  5. R Davis says:

    How many of these U.S. or otherwise, shale drillers eager to lock in future production are actually producing shale oil, in the first place.
    Not many I bet.
    For as long as no one goes out into the field to look, the shale oil drilling phantom will live on.
    We have our own snake oil dealers here in Australia.

  6. R Davis says:

    As the 6th largest economy & with one of the worlds largest automotive markets, the proposed ban on the internal combustion engine could have significant impact far beyond Frances borders.

    EU countries want to ban all vehicles that run on gas or diesel.
    Optometrist to say the least. One EU official I heard on radio said they can all ride bikes, it is healthier for everyone.
    Has mental illness or perhaps dementia, hit the EU in some substantial way ?
    And what would such a ban, if put into play do for oil prices ?

  7. Mily says:

    Backward action has been Saudi’s wet dream for a while so the frackers can’t hedge with better 2Y “contangoed” price, and voila, they managed to pull this off. They learnt how to apply forward guidance jawboning from fed like pros

    • Mily says:

      *Backwardation. My phone spell check thinks it knows futures trading better

      • Jaco says:

        The backwardation sure hasn’t helped equities much. There is a HUGE disconnect/reformulation between equity price rise and that of the actual commodity.

  8. michael Engel says:

    Oil have completed the first leg a up, from the bottom of Feb 2016(L)
    at $26.05 to this Friday(H) @ 59.05.
    It’s leg a, part of a-b-c up.
    The next leg b lower targets are $31 – $37.
    After that, a leg c up perhaps to $80 to $100.
    It will take years, for a-b-c to be completed.
    When done, a counter trend Leg 4, a big one, will be completed and a new leg, Leg 5 down, another big one, will start.
    Shall I stop here, with stupid fake predictions ?
    One more comment, if you don’t mind :
    The 2008 high @ $147 was followed by a correction. That will be over
    only when Leg 5 will be done (the whole move down have started in 2011).
    Thereafter, a new gigantic wave up, with oil well above $147, will start at that point.
    The $USD, I assume, will go the opposite way ==> lose it’s value.

Comments are closed.