What Can Shale E&Ps Oil Hedging Positions Tell Us
June 2017
US E&P companies have increased crude oil hedging by almost 50% from 2Q 2016 to 1Q 2017. Indeed, the majority of US companies have hedged part of their production for 2017. The increase in shale production in recent years can be seen in the WTI futures market. While open interests reach record high levels, long-term future contracts are steadily falling.

How Much to Hedge?

Hedging activity, in which companies use future contracts for oil delivery to lock-in a price per barrel, have increased significantly in the US. The use of such financial products is helping operators to limit price volatility risk, and thus facilitate the access to capital and expand drilling campaigns. From 2016 to 2017, US E&P companies increased crude oil hedging by almost 50

A typical oil producer hedges less than half of its expected production. Hedging more would increase exposure to risks –associated to factors such as operational hiccups or weather events– that do not allow the producer to deliver the hedged volumes. Hedging too much also limits upside potential in the event of an oil price increase. Therefore, producers regularly weigh the certainty of locking-in a price for future production, against the risk of giving away substantial revenue if prices rise. Price protection becomes much more attractive when oil prices are seen to be threatened on the downside and investment is increasing.

The appetite for price exposure varies with the size, level of debt and strategy. Historically, the largest and financially strong companies have minimal hedging, while smaller producers have been more aggressive in protecting future revenues. Five of the 10 largest US E&Ps by market capitalization have none or very little of their 2017 production hedged.

The type of field development a company operates also influences hedging strategy. Front month-to-24month future contracts, which protect near-term returns, is critical for shale well economics. (Figure 1) Shale wells have high initial production rates followed by very steep decline rates, so securing prices for 1-2 years can ensure the viability of a shale well, and ensure cash-flows to continue drilling. The increase in shale production in recent years can be seen in the WTI futures market. While open interest reach record high levels, long-term future contracts (36-to-48 months) are steadily falling. (Figure 2).



The recent oil price downturn has led to a wave of consolidation and high-grading of acreage to improve cash-flow. It also reduced the appetite for price risk. Today, shale operators are highly leveraged, larger, and hold an extensive inventory of drilled-but-uncompleted wells (DUC). As long as a constant price per barrel can be guaranteed, shale operators should be able to keep drilling and delivering higher volumes, independent of short-term price swings. In this context, a strong hedging strategy makes sense: protect near-term cash flow even at the expense of limiting the upside if the focus is on short-term growth.


What US Shale Hedging Tells Us About Near-Term WTI Prices

The prices level upstream companies hedge at does not necessarily reflect their price forecasts. It does, however, show how much they need to guarantee returns including capex for growth plans and loan repayments. So hedging levels are a better indicator of a company's cost structure than a price forecast.

In the fastest growing oil play in the US, the Permian, oil companies have hedged about 65% of their expected oil production for this year at a weighted average price of US$49.43/bbl. The median price is less than US$47/bbl. More than half of producers have also hedged 2018 full year production, at a slightly higher price (~US$55/bbl). A country-wide analysis shows 43% of 2017 output was hedged at an average price of US$50.3/bbl. (Figure 3)

Shale hedging positions highlight an interesting dynamic. The current futures price for 2018 is about US$50/bbl, around where futures prices for the rest of the decade have stabilized since early 2016, even as near-month prices have gone up and down. While futures prices are not predictions, the stability of those longer-term futures suggests that US shale producers' costs –as reflected in their hedging programs- are expected to be price setters in the oil market in the next few years. (Figure 4).



All of which leaves OPEC and its allies in a bind. Even the strongest in their ranks, Saudi Arabia, can only stomach US$50/bbl for so long –while Venezuela could face catastrophe. That is why markets were certain that the cuts would have been extended in their latest meeting the 25th of May. If shale producers can grow with oil at US$50/bbl, then other producers will have to adapt to that level. Moreover, if OPEC succeeds in pushing up price expectation, with extended supply cuts, shale producers will thank them by locking in more hedges for 2018. They will use the cash to put more rigs to work and eventually pull those prices back down. This would mean shale producers backed by their financial tools and nimble operations have effectively removed –or significantly reduced– the pricing power away from OPEC.

This theory will be further tested this year. Oil futures for 2018 have recently dipped back below US$50/bbl, making it less appealing to hedge next year's production. This, in turn, is already reflected in the decrease in hedging activity during the 2Q 2017 and could cause the ramp-up in shale drilling to phase out towards the end of 2017. Short-term future prices and shale hedging positions will be the critical number to watch.