Wednesday, July 31, 2013

Hedging and Thin Markets

The Financial Times had an interesting article about the problems plaguing independent shale oil producers trying to hedge price risk. Rising production of shale oil has led to a huge increase in US oil production. As producers invest in new production they typically sell oil forward to lock in prices so that they can obtain credit. But as they do this the price for future delivery declines. As high prices are the basis on which unconventional oil production makes sense, this is problematic:
Since the start of 2011 crude production from the Bakken field in North Dakota, the most prolific US shale oil field, has nearly tripled. During the same period the price of benchmark West Texas Intermediate three years ahead has tumbled from more than $105 a barrel in April and May 2011 to as low as $81.51 by June this year.
That is a worry for the independent companies that dominate US shale production. To attract the credit they need to keep drilling, most of these companies sell futures contracts to show lenders they have locked in an oil price that is higher than their cost of production.
...The principal reason for the downward drift in prices, say analysts and traders, is the hedging activities of shale oil producers themselves. As the volume of production in the hands of independent producers grows – EOG, a bellwether independent oil producer, doubled crude and condensate production between 2010 and 2012 – so does their hedging activity. 
The problem is that the futures markets tend to be quite thin as you move out into the future. Users of oil do not engage in significant amounts of hedging three years and further out into the future. So the actions of producers tend to have large effects on price. 

Hence, we have the situation where the markets signal a large future decline in the price of oil, based on a boom caused by high prices of oil. Hence, we have a situation where the markets signal a large future decline in the price of oil, based on a boom caused by current high prices. The increase in supply has been caused by high oil prices. Clearly, if oil prices were really expected to fall by $20 a barrel in the next couple of years, many shale plays would no longer be profitable.

Two points seem important here. First, the futures market may not be giving us the best signal of what prices may be no matter how efficient it is, simply because it is too thin. Second, oil producers cannot use futures markets to significantly hedge price risk. 

This point is all the more important if we think of conventional oil producers who also must make huge investments on a very large scale. When we talk about the implications of price risk for investment in East Siberia economists often ask why Russia does not hedge the risk in the futures market. Now ask yourself: if the actions of independent shale producers can depress futures market prices, what would happen if Russia tried to hedge its production? Ten percent of Russian oil production is about the size of the entire annual production from the Bakken shale!

With markets so thin producers cannot hedge price risk with futures or options. Risk sharing must take other forms. I will talk about this in future posts.

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