Up Front

Hedging, Thin Markets and Russia’s Future Oil

Barry W. Ickes

Today’s Financial Times (FT) (July 31, 2013) featured an interesting article about the problems plaguing independent shale oil producers trying to hedge price risk [Ajay Makan, “U.S. shale revolution triggers oil derivatives upheaval”].  Although not mentioned in the article, this story has some implications for a dilemma faced by many oil producers in today’s uncertain market, even by major players such as Russia.

Rising production of shale oil has led to a huge increase in overall U.S. oil production.  As producers invest in new production, they typically sell oil forward to lock in prices and, by doing so, obtain credit.  However, as they do this the price for future delivery declines.  Since high prices are the basis on which unconventional oil production makes sense, this decline is problematic.  The FT writes:

“Since the start of 2011, crude production from the Bakken field in North Dakota, the most prolific U.S. 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 U.S. 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 or more into the future.  Therefore, the actions of producers tend to have large effects on price.

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 latter point is all the more important if we think of conventional oil producers who must also make huge investments on a very large scale.  Russia is an obvious case in point.  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 in the U.S. can depress futures market prices, what would happen if Russia tried to hedge its own production?  Ten percent of Russian oil output is equivalent to 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.  This will be a topic for future posts.