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Why Is Oil Price Tumbling: Oil Hedges Were Just Rolled Over

Why Is Oil Price Tumbling: Oil Hedges Were Just Rolled Over

Why Is Oil Price Tumbling: Oil Hedges Were Just Rolled Over

One year ago, when oil prices first cracked and tumbled from $100 to a level some 60% lower, it took the US oil industry about 9 months to fully feel the pain and proceed with cash-saving production cuts as a result of extensive oil-price hedges that had been put on at the historical price, cushioning the blow from the price collapse driven by a drop in global oil demand coupled with a surge in Saudi oil production. The impact of these hedges was largely muted by the summer of 2015 when we first saw a notable decline in US oil production which had recently hit record levels.

And with oil volatility surging in recent months, oil producers needed to take advantage of a rally, technical or otherwise, and an oil vol lull to reestablish hedges, even if it meant at far lower prices than recent benchmarks.

This is precisely what happened in the past week following one of the most torrid surges in the price of oil seen in recent years.

So ahead of looming re-determinations, crude oil producers which piled into this decidely technical-driven rally to hedge aggressively in order to show a more stable asset base for creditors, but more importantly, to offload further price decline risks to their counterparties. Today’s reversal off $50 along with a surge in oil volatility suggests hedging activity has been aggressive, as further confirmed by Reuters..

And as a result of a new bevy of hedges put on around $50/barrell which coupled with the recent decline in the oil VIX leading to slightly cheaper hedges, firms can once again continue to produce at even lower prices as they have rebased their hedges thereby buying themselves a few more months of production at even lower prices – offsetting Saudi record production pressures. The biggest loser in this US hedging effort – the dwindling Saudi budget. The biggest winners: oil majors and other companies who rolled hedges for another 6-9-12 months, allowing crank up the production spiggot to max and generate an incremental burst in both cash flow, and production.

The details courtesy of Reuters:,

This past week, as oil prices barrelled 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.

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.

“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.

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.”

End result: oil has tumbled, as suddenly the specter of even greater production at lower prices is all too real, and one which will force Saudi Arabia to pump even more to put the higher-cost producers, those who just lowered their production costs indefinitely, out of business.

In other words: the race to the proverbial bottom, which Saudi seemed to be winning, has just been reset.

 

 

Courtesy: Zerohedge

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