U.S. Shale's Favorite Financial Trick Is Getting Less Attractive

EghtesadOnline: Oil bulls, take heart! U.S. drillers have dramatically reduced their hedging activity, a move that could portend a break in the production gains that have upended global crude prices.

News ID: ۷۷۶۱۷۱

14 May 2017

The relative cost of options protecting against a drop in West Texas Intermediate crude has fallen to its lowest since August, thanks to a big drop in producer hedging, Societe Generale SA said on Friday. The so-called put skew for contracts delivered a year from now -- weighing the difference in value between bullish and bearish options -- fell to just below 6 percentage points, after rising above 8 points in February.

According to Bloomberg, hedging contracts lock in payments for future production. U.S. drillers signed onto such agreements in droves late last year, after an OPEC-led deal to cut output raised prices. The Catch-22 is that the guarantees gave drillers the security to boost output, undercutting the rally. Now, futures have languished to the point that the industry’s favorite financial safeguard no longer makes economic sense.

The fall in WTI 2018 swap prices has made it “unattractive for most U.S. shale oil producers to hedge," Jesper Dannesboe, a London-based commodity strategist for SocGen, wrote in Friday’s report. Unless oil prices rally meaningfully, that will continue, he said.

Changes in drilling-rig counts on the ground tend to follow a few months after shifts in hedging activity, since many shale companies prefer to hedge new production before committing to more spending, Dannesboe said.

“In other words, the recent decline in WTI prices may, if maintained, over time cause U.S. oil production growth to slow meaningfully," he wrote.

WTI crude for June delivery rose 7 cents to $47.90 a barrel at 9:26 a.m. Friday on the New York Mercantile Exchange, after the U.S. reported a steeper-than-expected drop in crude inventories.

Standing Pat

In quarterly earnings reports over the past month, oil companies indicated they’d chosen to stand pat with their hedges this year, after the surge at the end of 2016. Apache Corp. and Anadarko Petroleum Corp., two of the most active hedgers last year, hadn’t added significant new contracts as of the end of the quarter, for example.

“Given that oil prices have declined so far in 2017, I would imagine that there was a deceleration in hedging activity," Peter Pulikkan, a Bloomberg Intelligence analyst in New York, said in an interview.

Still, drillers are also forging ahead with plans to increase production, in part thanks to the financial cushion provided by existing hedges. Pioneer Natural Resources Co., one of the most prolific actors in Texas’ Permian shale basin, has contracts in place for 85 percent of its expected oil and natural gas output this year, the company said on a May 4 conference call.

Pioneer has already hedged more than 20 percent of next year’s oil production and 15 percent of its gas volumes for 2018 as well, Chief Executive Officer Tim Dove told analysts on the call. Parsley Energy Inc., Devon Energy Corp. and RSP Permian Inc.also said they either had 2018 hedges in place or were planning to add them.

That’s likely to continue complicating the oil market. OPEC members plan to meet in Vienna on May 25 to discuss additional production cuts that could resuscitate oil prices. Dove, on his call, said he sees it as his next opportunity to lock in hedges.