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Hedging Rush In U.S. Shale Could Send Prices Tanking

The U.S. shale industry continues…

Oil Markets Not Convinced OPEC Deal Can Kill The Glut

Offshore oil rigs

There are serious questions swirling around OPEC’s production cut deal, ranging from the size of the cuts needed given that production from the cartel rose through November, to the prospect of cheating from individual members. But even if OPEC stays true to its word and follows through on the output reductions, there are reasons to question how sustained a rally in oil prices can be. And they go beyond the obvious knock-on increases in U.S. shale production.

Shale drillers have already started to hedge their production at higher prices since OPEC announced their intention to cut supplies by 1.2 million barrels per day last week. Companies are locking in oil sales through 2017 and even 2018 at prices above $50 per barrel. They crave the certainty of hedged prices even if that means forgoing any upside should spot prices surge higher.

“Right after OPEC, U.S. producers were very active hedging," Ben Freeman, founder of HudsonField LLC, told Bloomberg in an interview. "We are going to see a significant amount of producer hedging at this levels." Bloomberg says that a 580,000 options contracts traded on the NYMEX on the day that OPEC announced its deal, a record high.

But a wave of hedging will flatten out the futures curve, which essentially means that the locked-in oil sales are putting downward pressure on prices dated for 2017 and 2018. By hedging, oil companies can be certain about the prices they will be able to receive for their oil a year or two years from now, so they can feel confident about drilling today. That should lead to higher production next year from U.S. shale, which will somewhat temper the newfound bullishness in the oil market from the OPEC deal.

Similarly, the OPEC deal is narrowing the market contango. Contango, a pricing structure in which near-term oil contracts trade at a discount to contracts sold farther out into the future, has been prevalent since the downturn in the market in 2014. One way of interpreting a contango is that there is a near-term glut – oil traders have so much supply on their hands right now that in order to sell oil, it must be discounted. With OPEC promising to take 1.2 mb/d off the market beginning in January, the near-term suddenly doesn’t look as oversupplied as it did just a few weeks ago. Related: Oil Minister: Venezuela Has Left 500,000 Bpd Output Out Of OPEC Deal

However, while the OPEC deal pushed up oil prices, the narrowing contango could have a countervailing effect. When front-month oil contracts trade at a sharp discount to oil set to be delivered in, say, 12 months, then oil traders can make a profit by storing crude in onshore storage or in tankers at sea, and selling that oil for a higher price in a year. Indeed, both onshore and offshore storage has become commonplace over the past two years, and any increase in tankers being booked for floating storage is a tell-tale symptom of a glut in the market. Now that OPEC is succeeding in narrowing the contango (because fears of oversupply are easing), storing oil simply to profit from a sale at a later date will no longer make sense.

The six-month contango – the difference between front-month oil contracts and contracts for delivery six months from now – shrank from -$4.50 per barrel in November to just -$1.77 per barrel the day after the OPEC deal. Since storing oil on a tanker for six months costs between $3.15 and $3.38 per barrel, according to Bloomberg, parking oil at sea will be unprofitable.

The narrowing contango, as a result, could lead to unloading of oil from storage. If brimming inventories are drawn down, a flood of supply will hit the market, just as prices are starting to show some life. A rush of oil unloaded from storage will exacerbate the oversupply picture. Related: Trump Could Fuel A Nuclear Energy Boom In 2017

Of course, one could view this trend in exactly the opposite way: Everyone knew that there were record levels of oil sitting in storage, inventories that had to be drawn down in order for prices to recover. Indeed, the drawdown of inventories is a sign that the market is no longer oversupplied, since traders need to tap storage tanks to meet market demand. Sure, oil sitting in storage will add new supply to the market, but this was to be expected. Working through that storage will be a necessary step towards a tighter market. Thus, if inventories start to come down, it will be a bullish sign, not a bearish one. We see that every week when the EIA releases storage data – any drawdown is met with higher oil prices and vice versa.

The contango narrowed sharply in the immediate aftermath of the OPEC deal, a bullish sign. But it widened again in recent days on concerns about OPEC (and Russia) not following through on the promised cuts. All in all, the current differentials in oil futures suggests that inventory drawdowns will pick up in earnest in the second half of 2017, according to Reuters.

This was all a long-winded way of saying that the oil market will move closer to balance towards the second half of next year, and the weekly and monthly changes in inventories will be a good indicator to watch for figuring out when the market is tightening.

By Nick Cunningham of Oilprice.com

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  • Kr55 on December 08 2016 said:
    Don't forget how much control lenders have over producers now. They are forcing producers to hedge to ensure debt interest and principle can be paid to their satisfaction, with no regard for the long term growth of the producers. Lenders just want their money out.

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