NEW YORK – Welcome to the oil market’s new vicious cycle.
This past week, as oil prices barreled over 9 percent higher to break out of a weeks-long trading range, U.S. shale producers jumped at the chance to lock in $50-plus crude for the first time in months, making up for lost time after holding off hedging during the market’s late-summer slump.
U.S. crude oil futures for December 2016 delivery, a favored contract for hedgers, saw trading volume spike to a weekly record high of nearly 190 million barrels, twice as much as the average for the previous four weeks, in what market sources and industry executives said was the biggest wave of hedging since a fleeting rush in late August.
The price premium for the Dec 2016 contract against the same month in 2015 has shrunk to just $4 a barrel, down from more than $7 a barrel two months ago, due partly to forward selling.
Oil producers’ rapid response to the latest move upward comes in contrast to the second quarter, when a moderate price recovery was met with only modest hedging interest as many executives bet – wrongly – that the worst was already behind them.
It also highlights the far more precarious financial position for many shale firms facing rapidly tightening credit conditions, expiring legacy hedges and a deepening fear that prices may stay much lower for much longer than they thought.
For some, hedging is now less an insurance policy than a lifeline as those who have scrimped on protection watched with despair oil prices shuffling between $43 and $48 for six weeks.
Yet their activity also threatens to undermine one of the fundamental reasons for oil’s gains: falling U.S. output.
In addition to creating immediate headwinds by selling into the rally, drillers whose future profits are insured with new hedges will be better able to keep on pumping oil, adding to a global oversupply, the thinking goes.
“Any little rally ends up getting suffocated by the new production it unleashes,” said Vikas Dwivedi, Houston-based global oil and gas strategist at Macquarie Group.
The push-pull between current prices and future production highlights a new normal for oil markets, in which the short-run cycles of the agile U.S. shale sector have replaced OPEC as the world’s swing supplier. The $50 hedges also illustrate how shale firms have been able to keep drilling at lower and lower costs thanks to efficiency gains and focus on the most productive spots; a year ago, break-even costs were seen nearer $70.
As a result, producers are moving more quickly than ever to catch what may be a fleeting price recovery.
In a push that started Tuesday and continued through Friday, U.S. producers have locked in new production in greater volumes for 2016 and 2017, according to three market participants who watch money flows.
Last week, the average price for all 2016 contracts on the U.S. WTI benchmark – known as the “strip” – rose more than 7 percent to above $53 a barrel, near its highest since late July. Apart from a fleeting price spike in late August, it is the broadest gain since April. The 2017 strip traded above $55 a barrel.
“What we’re seeing now is one of the better opportunities for producers to hedge,” said John Saucer, vice president of research and analysis at Mobius Risk Group, which advises firms including producers on energy hedging strategies.
Urgency displayed by producers in locking in present prices may be due in part to timing. Some firms are still engaged in the bi-annual process of reviewing, or ‘redetermining’, credit lines with banks. Lenders are under pressure to cut back on funding as falling oil and gas prices have slashed the value of reserves that serve as collateral.
“When producers are heading into redeterminations – all of a sudden, you’ve done something to shore up your potential borrowing base,” said Saucer.
And most firms have a lot of shoring up to do.
North American exploration and production companies so far have only hedged 11 percent of their expected 2016 oil and gas production, according to a study of 48 firms published by consultancy IHS Energy last week. That is down from 28 percent for the rest of 2015.
To be sure, many producers may still be holding back, hoping for a more sustained upswing. One influential forecaster, consultancy PIRA Energy Group’s Gary Ross, told clients last week that oil was headed above $70 by 2017.
If so, the market would face another, even larger, wave of producer selling around $60 to $65 a barrel. Michael Tran, an energy strategist with RBC Capital Markets in New York expects that to be “the key level of interest for producers to really ramp up hedging programs in larger size.”
(Reporting By Catherine Ngai and Jessica Resnick-Ault; Editing by Jonathan Leff and Tomasz Janowski)
This article was written by Catherine Ngai and JESSICA RESNICK-AULT from Reuters and was legally licensed through the NewsCred publisher network.