U.S. shale producers are locking in prices for their production as much as three years into the future in a sign that strong domestic crude pricing is nearing a peak, according to market sources familiar with money flows.
U.S. crude prices for 2019 and 2020, based on an average of each year's monthly contracts, have climbed this week above $68 and $64 a barrel, respectively, the highest levels in over three years. The rally comes even as front-month prices have dropped from the 3-1/2-year highs touched during the summer.
"Hedging activity has picked up considerably over recent weeks and this will continue to be the case as producers begin to frame budgets for next year," said Michael Tran, commodity strategist at RBC Capital Markets, noting the rally in forward prices are encouraging the producer bets.
Hedging can reduce risks associated with volatility in oil prices, acting as an insurance contract to lock in a future selling price and fix spending plans. Such longer-term bets signal U.S. producers will continue to expand output, keeping a lid on prices, according to crude traders and brokers.
The nation's output this year has climbed above 10 million barrels per day (bbl/d), close to top producers Russia and Saudi Arabia. That output is forecast to grow next year by 840,000 bbl/d to average 11.5 million bbl/d.
There was a large uptick in crude swap activity last week, with just shy of 8 million barrels changing hands in a day, an energy derivatives broker said, signaling strong hedging interest. Swaps are a type of contract that allow producers to lock in or fix the price they receive for their oil production.
Almost 80% of the swap activity was split evenly between calendars 2020 and 2019, and the remaining 20% for this year, the broker said, adding that there was a small amount of calendar 2021 activity during the week.
The market sources declined to say which oil companies were actively hedging in recent weeks.
The move to hedge at these levels could prove risky for producers in a market where the price of oil for immediate delivery is higher than for later deliveries.
Many U.S. shale producers hedged second-quarter production at about $55 a barrel, which backfired as U.S. crude climbed to more than $70 a barrel last quarter, the highest level since 2014.
As a result, producers are using more "collars," a financial instrument that provides price protection on the downside while allowing them to share in some of the upside if prices rally.
"We've been building a lot of collar structures," Christian Kendall, CEO of Denbury Resources Inc. (NYSE: DNR) said last week, noting that the instruments will protect its production at about $60 a barrel and provide upside if oil rises to the high $70s per barrel.
Denbury is nearly 50% hedged for 2019 and will add hedges to get to 60% to 70% of production, Kendall said.
Meanwhile, oil companies that drill in the Permian Basin of West Texas and New Mexico, where local prices are $14 below futures because of full pipelines, are turning to a type of hedge geared to protecting them against regional weaknesses.
"We have done an extensive amount of basis hedging," said Jay Ottoson, CEO of SM Energy Co. (NYSE: SM), which reported 11.2 million barrels of 2019 Permian oil production covered by basis hedges compared with 6.9 million barrels of 2018 production similarly covered at this time last year.
Permian producers increased their 2020 oil-basis hedge positions by more than fourfold last quarter over the prior quarter with Concho Resources Inc. (NYSE: CXO) and Energen Corp. (NYSE: EGN) leading the surge, said consultancy Wood Mackenzie.
For 2019, Midland-Cushing basis hedging rose by 52% and the consultancy attributed the sharp increases to worries that new pipelines may be delayed past their planned startups beginning in 2019.
Open interest in U.S. crude futures for delivery in 13 months to 36 months and beyond has grown in almost every month so far in 2018, CME Group Inc said.
Oil producers are "saying 'we're comfortable with our hedging in the front; we have appropriate hedges in place but what's going to happen next,'" said Owain Johnson, managing director of energy research and product development at CME Group.