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 of Oilprice.com
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