Oil producers are changing their hedging habits to counteract volatility in the global market.
Oil producers are changing their hedging habits to counteract volatility in the global market.

Like any business, oil exploration and production companies take steps to reduce financial risk, sometimes involving complex tactics. But as oil prices become more prone to sharper peaks and valleys, the industry has reduced some of its risk-hedging activity compared to recent years.

A study of E&P firms from Bloomberg examined how U.S. oil producers hedge their finances in response to market fluctuations. The most common method is the use of futures contracts, which allow drilling companies to lock in a future price no matter what happens in the broader market. But even this attempt at risk aversion creates its own opportunity for betting and losing. Futures contracts could be issued to take an optimistic view of the oil market over the next month or so, selling for more than whatever the current spot price is. They may also take the opposite approach and sell contracts short of their present value.

Bloomberg’s research into 37 U.S. E&P companies found that most are selling more short contracts now than they were less than 10 years ago. Although the situation has improved drastically since 2014, oil producers are still coming up about 200 million barrels short of where they need to be to achieve market balance and profit.

Since 2007, some trends could be seen in hedging activity among producers and explorers:

  • From 2007 to 2008, the prevailing thought in the energy industry was that oil supplies had reached their peak and would only decline from that point on. This meant almost no one sold barrels short until around 2010.
  • Beginning in 2009, though, the oil market hit a slump in tandem with the global recession. At the same time, hydraulic fracturing allows for greater crude yields. Without much promise in the retail market, short-selling becomes a common way to finance investments.
  • Short positions hit their lowest point in 2013, but hedging activity has generally slowed since then.

Hedging patterns shift
Curiously, Bloomberg’s analysis found that oil companies may be using hedging differently in 2017. Whereas short-selling became less common in times when oil prices were on the rise, it appears the opposite is currently true. Oil prices have been slowly creeping up to exceed $50 per barrel, but 32 of the 37 production firms surveyed by Bloomberg were hedging their price bets for 2017 and beyond. Around 43 percent of those firms were predicting either no net change in price, or even a slight drop.

In addition, hedging is increasingly being used not to bet on future prices, but simply to sell inventory faster. Bloomberg reported that most major E&P firms working in the shale-rich Permian Basin have already sold significant amounts of anticipated 2017 output at less than $50 per barrel. While they could feasibly sell these contracts at a higher price, it’s more likely this hedging is being done more to protect market share than boost profits. It’s a tactic torn from a similar cloth as OPEC, which is also now sacrificing earnings in exchange for continued business by scaling down production.

Bloomberg analysts predict that if shale producers are willing to sell their oil at such a thin margin, it’s likely an attempt to win a war of attrition on prices. Competitors around the world will be forced to lower their prices if they want to compete for business.