U.S. oil companies have stepped up their hedging for 2018 production, locking in sales at higher prices.
In the fourth quarter, U.S. producers increased the share of their 2018 output secured under hedges to 48 percent, up from just 30 percent in the third quarter, according to a Goldman Sachs note. “Hedging has moved from normal levels to above-normal levels, aided by an increase in oil futures (2018 WTI now $60),” the investment bank wrote. “This should allow many producers to grow, while spending within cash ?ow during 2018.”
Goldman says that drillers will incrementally add more hedges for this year, and they are just beginning to do so for 2019 production. About 9 percent of 2019 production is hedged at an average price of $58 per barrel.
The bank estimates that many shale companies will be able to balance their books with WTI at $56.50. Because WTI is currently trading just above $60, that suggests that many shale drillers could post positive cash flow this year, essentially for the first time.
The majority of companies are hedged at roughly 50 percent, which should help them maintain capital discipline, Goldman analysts said.
Meanwhile, Standard Chartered’s survey of 73 U.S. energy companies finds that hedging increased by 22 percent in the three months ending on February 1, a sign that the shale industry continued to step up their hedges into 2018 as oil prices rallied at the start of the year. Standard Chartered puts the proportion of 2018 oil production from the surveyed companies at 63 percent. Related: Canada Is Facing A Heavy Crude Crisis
For its part, Goldman forecasts an average oil price of $72.50 per barrel for this year, which would mean that the majority of companies would lose out by being locked into hedges. If prices stay where they are now – in the low $60s – there would be not much change in earnings for the hedged versus non-hedged producer.
While there is a danger of missing out on the upswing if the oil market tightens later this year, hedges will also protect companies from any market downturn. Forecasts of explosive shale growth are being watched with concern, and hedge funds and other money managers have recently stepped up their short bets on oil futures.
Also, while the WTI futures curve has been in a state of backwardation for much of the past two months, the curve has recently flattened out as the bullish sentiment has started to disappear. The spread for the first two WTI contracts is "dangerously close to switching from backwardation to contango," Bob Yawger, director of futures division at Mizuho Securities USA Inc., told Bloomberg. "That would be a very negative price development.”
A contango is a situation in which front month oil futures trade at a discount to longer-dated futures, which is typically interpreted as a sign of bearishness. Backwardation, in which front month contracts trade at a premium – the opposite of contango – had emerged a few months ago for the first time in a long time, and the development was seen as a sign that the oil market was finally beginning to balance.
The return of a contango would likely cause oil trading to become more volatile, and perhaps could push spot prices down. “If you’re taking a speculative short position, you’re looking at what U.S. production is going to do,” Ashley Petersen, an analyst at Stratas Advisors, said in a March 9 Bloomberg interview. “There’s starting to be a little bit of a turn in sentiment.”
However, Goldman Sachs does not agree that things are about to sour. The investment bank says that oil demand “remains robust,” shale drillers actually showing some relative restraint when it comes to new drilling, and OPEC continues to post high compliance rates with their production limits. That will likely push inventories well below the five-year average by the third quarter, the bank says.
But because there is such wide variation in expectations for oil prices, it is no surprise that so many shale companies have locked in hedges to at least offer some certainty.
By Nick Cunningham of Oilprice.com
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