There has been no window of opportunity for producers to hedge term exposure this year despite price rallies in the front of the market.
As you can see in the chart above, price rallies have been fairly isolated to the front of the market (green line). Producers had an opportunity in both Q2 and Q4 of 2019 to hedge 2020 price exposure. In fact, in Q2 2019, they even had a decent shot at hedging their calendar 2021 exposure (hot pink line) in WTI at prices above $55, though few did. As for the rest of the curve (calendar 2022 and beyond), there has been no real rally in prices in reaction to front-led rallies. Yet, the minute the front of the market sold off, the back of the curve collapsed in kind. Those holding out for term prices to get pulled up by the front of the market saw hedging opportunities vanish before their very eyes over the last 2 weeks.
To get an idea of producer hedge positions, we look at 3 large US producers (Pioneer, Occidental and EOG) and their respective reported hedge positions as of the end of Q4, 2019 (we recognize that positions could have materially changed since the end of 2019 in which case 1Q filings are something to keep an eye on). Regardless, there is an interesting contrast between the 3 companies positions based on timing and style of hedges. First up, we have Pioneer Natural Resources.
Excerpt from Pioneer Natural Resources fourth quarter 10-Q filing:
"Cost-less Collars" have become a common hedging tool used by energy producers. Rather than lock in sales prices using futures or swaps, Wall Street has capitalized on the 'sellers remorse' this creates and offered up an age old option strategy that allows producers to feel like they have 'downside protection' while not committing to a specific fixed sales price.
To refresh, a cost-less collar (or zero-cost collar as it is sometimes called) is established by buying a protective put while writing (selling) an out-of-the-money covered call with a strike price at which the premium received is equal to the premium of the protective put purchased (covered call due to the fact that the producer is long the underlying commodity). This has been further complicated over the years by the put skew in the market making it difficult to collect enough premium from selling a call to pay for the purchase of a put option. To remedy this, producers sell a further out of the money put to bring the net price of the structure as close to zero as possible.
Combining the option position reported by Pioneer in their 4Q filing with Brent futures (as Pioneer measures their options against Brent prices), we get the following chart:
We can see that the next 12 months of futures prices are below their long put strike of $63/bbl, and as of last week, have breached their short put strike of $54/bbl. The $9/bbl 'made' between $63 and $54 means that this producer doesn't start 'losing' money until prices move below $45 ($54 less the $9 collected between $63 and $54). However, every move in Brent prices below $54 is still a reduction of hedge protection. Also note the lack of position reported in calendar 2021 other than the small sale of some $72 call options.
Next, we look at Occidental Petroleum.
Excerpt from Occidental Petroleum 4Q investor presentation:
Here we see the producer specifically referencing the above-mentioned "Costless Collar". These positions are also referenced against Brent prices. Again, also note the lack of downside protection other than call sales for calendar 2021.
In Occidental's case, the reported long put strike ($55) is lower than that reported by Pioneer ($63). This means Occidental, in this case, did not get the benefit of their downside protection until the market fell below $55, but as a result have not breached their put sales strike of $45.
Finally, we look at the reported hedges of EOG Resources
Excerpt from EOG Resources fourth quarter 10-Q filing:
Here we see that EOG appears to have used fixed price term swaps in WTI as a hedge, with different volumes and prices by quarter. In this way, they give away price moves above $59, but do not have to worry about the breach of put strikes on the downside. However, the reported hedge volumes drop off significantly in the third quarter and as of 12/31/19, they reported no hedge volumes in Q4 or beyond. As we saw in the first chart of calendar strip prices, any new hedges they would establish from here would be a good $10+ lower than existing hedge levels.
It's no wonder energy equities continue to be under pressure. Without a heroic rally in term prices, further cost-cutting may be the only way to flow profits to the bottom-line once 2020 hedges roll off the books. In addition, should prices fall much more, short put positions could cause some interesting action going forward by producers. Keep in mind where term oil prices need to go in order for producers to replace existing hedge levels in 2021 and beyond.
Spreads and Inventories
Inventory levels and calendar spreads are inversely correlated over time at pain points (chart below). The move from backwardation to contango in WTI calendar spreads has been widely reported as time spreads are often used as bull/bear indicators. On a macro level, calendar spreads are also inventory signals. Contango motivates storage injections and backwardation is used as a market signal to draw down inventories. Using a broader historical lens we can see how this pattern has played out over the last 15 years (red line = EIA Cushing inventory levels).
There are some fairly striking moves prompted by calendar spreads on inventory levels (when inventory levels are high, contango abates and backwardation draws barrels out of the ground and vice versa). The super-contango that ensued after the financial crisis led to a build in Cushing inventories. Just as backwardation drew barrels out. With Cushing inventories sitting just below 40,000 barrels, the market is still undecided as to whether it wants to incentivize builds as markets tentatively dip into contango. If not, future prices could come under further pressure if the front doesn't rally.
Finally, we saw a small sign of bottoming in ULSD cracks last week as oil prices (black line) collapsed faster than product prices.
This is a bit more striking when we look at monthly ULSD cracks vs WTI Month-1 continuous futures.
If US products can find a home via local demand or through the export market as low prices become attractive, WTI prices should eventually follow suit. Otherwise, any rally in oil prices met by further selloffs in crack spreads will result in the next wave lower in oil prices.
INVENTORY RECAP
The EIA inventory report for week ending February 21, 2020 reported a total inventory DRAW of (4.30) million barrels with Crude oil showing a slight build.
Year-to-date, this bring us to a Total Inventory BUILD of 16.50 million barrels.
As noted above, inventory LEVELS compared to this same week in previous years continue to show product inventories slightly above the prior 2-year levels.
Lee Taylor - Technical Levels
BRENT
Resistance:
Support: 47.97/46.50/41.44
Friday’s continued sell-off took out the continuation Brent low of 50.22 of December 26th, 2018. One must closely monitor the Brent weekly charts to find realistic support levels. $47.97 then 46.50 then 41.44 stand out on the charts as support levels; however, the market should find plenty of support from 47.00 down to that 46.50 point. May/June Brent has rallied nicely since bottoming out at -.40. Look for support in the spread at -.01 with resistance at +.11 then +.27. As long at KM Brent stays above flat, we should see a retest of +.27 then +.43.
WTI
Resistance: 44.35-44.47/45.10/45.88
Support: 42.36
After a tumultuous week of the market getting hammered day after day, it appears as if the weekend didn’t provide much relief. Technically, the market is oversold but realistically no one has a clear idea where the bottom might be. Friday’s low was broken on Sunday night’s reopen but the true support level is 42.36, which is from Christmas Eve in 2018. Resistance levels are found at 44.35-44.47 in April WTI, then 45.10 then 45.88. Resistance levels aren’t going to come into play until there is some positive Coronavirus news. April/May WTI has support at-21 with resistance above at -12. May/June WTI has resistance at -14 with support below at -17 then -26.
RBOB
Resistance: 1.5034 - 1.505
Support: 1.4345-1.4360/1.4190
April RBOB has taken a beating just like the rest of the energy complex. Like many of the technical charts in energy, one must be creative to find significant support levels for each commodity. Once again looking at the spot continuation chart for gasoline, there is support at 1.4345-1.4360 followed by 1.4190. On the flip side, resistance lays above at 1.5034-1.5050. March/April RBOB is finally off the board, but it finally reached our objective of -9 cents. April/May and May/June were on track to follow HJ RBOB on its rally but finally relented to the flat price sell-off. JK RBOB needs to hold 48 to sustain another rally and break through 67. If it fails 48, look for a move down to 20. May/June is struggling and will not look promising until it settles above 80. Take a peek at the Q3 spreads like Sep/Oct that are completely oversold.
HEATING OIL
Resistance: 1.4796/1.4940
Support: 1.4666
The heating oil market finally reached the lower level of 1.4666 but now it needs to settle this week above, if not then technically it will look horrendous. Resistance will be in gaps above – the first level is 1.4796 then 1.4940. April/May heating oil has major resistance at 50, a settle above that level projects to 79 then well above 150. If this market takes another downturn, April/May will need to hold 21. Heating oil spreads look promising and look no farther than June/Dec heat. A settlement above -589 will project this spread to -533 then retest that enormous resistance of -351.
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