With Physical Hedging on Rise, Production Response May Weaken
With OPEC and non-OPEC production cuts on the horizon (although not guaranteed), institutions exposed to oil have shifted their outlooks for price risk, as reflected in their current positions in NYMEX WTI futures and options. As the WTI forward curve has shifted into backwardation, analysts are calling for swollen inventories to be drawn down towards the middle of 2017, pulling the market back into balance.
Physical Holders Show Increased Hedging
The physical industry continues to build its net short positions, although long positions are also increasing after reaching their nadir in the fall of 2015. Changes in both long and short positions tend to increase more or less in tandem. Producers, marketers, processors, and users currently hold over a billion barrels worth of oil in NYMEX WTI futures and options, more than one hundred times what is produced daily in the United States.
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Hedging among E&Ps has increased heavily going into 2017, with producers eager to lock in prices above $50 per barrel. Unfortunately, these categories are not further broken up in CFTC’s reports. If rising oil prices are expected, producers would likely account for the majority of long positions in the data.
Physical holders of oil such as midstream providers prefer to go short on oil in order to profit from whatever price declines occur. E&Ps generally do not hold their oil, selling it to midstream providers the second the oil leaves their gathering systems.
Managed Money Continues to Be Long
On the managed money side, hedge funds have built up record crude long positions on the expectation that OPEC and non-OPEC production cuts will successfully rebalance the market and reduce excess stocks in the second half of 2017.
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In the months since OPEC initiated talks, long positions by money managers have increased while showing greater volatility. Hedge funds often seek to profit from the influence OPEC announcements have over the market, as shown in the much greater volatility of short positions versus long. Related: Are Proven Oil Reserves Just A Political Tool?
Some analysts have commented that long-positions held by hedge funds could pose significant downside risk if prices fail to continue increasing and managers seek to lock in their profits by liquidating part of their holdings.
Swap Dealers Net Short Positions Up Significantly
Swap dealers have shown a noticeable increase in short positions over the past four months, with a particularly steep increase since the November 30 OPEC announcement. Swap dealers often serve as counter parties to producers looking to hedge their production. It’s worth noting that the current short positions among swap dealers (~400 MMBls) are roughly even with current long positions at PMPUs.
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The spike in short positions among swap dealers is likely the result of the increased hedging seen among E&Ps. EnerCom’s December Monthly report on E&P hedging found that over half of all producer hedge positions are based on swaps, with other products marketed by swaps dealers such as collars also popular.
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Will Increased Hedging Deaden U.S. Shale’s Production Response?
Despite optimism over announced cuts, many trends suggest market oversupply will continue. OPEC nations continued to increase production in the months leading up to the Nov. 30 announcement and have spotty compliance records. Meanwhile, the U.S. land rig count continues to increase, many companies have announced higher capex plans for 2017, and U.S. production has started to tick up since early September. Related: Plunging Natural Gas Inventories Pull Prices Even Higher
With E&Ps continuing to push drilling efficiencies and focusing on premium rock while prices hold above $50, more and more oil is starting to become economic to produce. If more physical oil deliveries are successfully locked in at decent prices, their responsiveness to price could be deadened. U.S. shale is a critical swing producer and plays a major role in the supply demand balance.
If OPEC nations do not follow through on promised cuts and the glut continues, oil prices will dip lower. Could we see another glut of production going into 2017? Much depends on OPEC’s ability to make good on their promises and on U.S. shale’s ability to stay flexible.
By Oil & Gas 360
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