One month ago we presented the simple reason why numerous oil producers did not believe the oil rally: they were aggressively hedging future production at prices - some as low as the mid-$30's - which were considered uneconomical as recently as 6 months ago, and while they were eliminating future downside risk should oil resume its plunge, they would also cap their gains should oil continue surging. In other words, those who hedged were confident the rally had peaked.
As a trader quoted by Reuters said then, "Brent's flattening contango since January comes as many producers want to cash in immediately on recent price rises. They've been heavily selling 2017/2018 and beyond, and it shows that they don't quite trust the higher spot prices yet. This means that even the producers don't really expect a strong price rally until well into 2017 or later."
Then last night, the WSJ also picked up on this and wrote that "in an about-face, companies are using hedges to lock in prices that they turned their noses up at a few months ago. Last September, Energen Corp. officials told investors they would hold out for roughly $60 a barrel before using the futures market to hedge their production. But the company recently said it had locked in about half of its expected 2016 production—or more than 6 million barrels—at around $45."
Many others have followed suit: EV Energy Partners LP hedged in recent weeks at prices slightly above $40, even though last spring it opted not to hedge when prices were between $50 and $60, finance chief Nicholas Bobrowski said. “We thought we were smarter than everyone,” Mr. Bobrowski said of the missed opportunity. “Lessons learned.”
Others have learned from his lesson too and have rushed to hedge.
Here the WSJ repeats the simple logic of hedging, namely that doing so now "means giving up possible higher prices if oil continues to improve. Producers have pounced anyway—due to pressure from their investors and fear that the rally could be temporary." They are far more worried not about lost gains as much as another round of major losses should oil tumble back to the mid-$20s.
And as the chart below shows, the hedging scramble has been vicious, with nearly 60% of small/midcap hedging their output, and nearly 50% of large caps doing the same.
The reason is simple: as the WSJ writes, "while many oil-company executives say prices will continue to rise in coming months, some don’t have the financial rope to chance it any longer given oil’s wild swings between $26 and $44 a barrel so far this year."
In any case, having locked in their potential upside and protected on the downside at levels which are far less profitable yet still economic for shale companies, what happens next is simple: production is resumed. After all, if one has no incentive to delay pumping until the price of oil rises, one will pump right now.
That is precisely what Pioneer Natural Resources announced moments ago in its Q1 earnings, in which it admitted that the next big move for US shale will be not to shutter production but to resume pumping, to wit:
- producing 222 thousand barrels oil equivalent per day (MBOEPD), of which 55% was oil; production grew by 7 MBOEPD, or 3%, compared to the fourth quarter of 2015, and was significantly above Pioneer’s first quarter production guidance range of 211 MBOEPD to 216 MBOEPD; oil production grew 10 thousand barrels oil per day during the quarter, or 9%, compared to the fourth quarter;
- expecting to deliver production growth of 12%+ in 2016 compared to the Company’s previous production growth target of 10%; the higher forecasted growth rate reflects improving Spraberry/Wolfcamp well productivity;
And the kicker:
- expecting to add five to ten horizontal drilling rigs when the price of oil recovers to approximately $50 per barrel and the outlook for oil supply/demand fundamentals is positive
PXD's breakeven pricing may not speak for the entire industry, but it surely does for many, and certainly for those who have hedged. Which means that should oil rebound by another $6-7, that 600,000 drop in US shale production from its peak will once again resume shrinking, which in turn will mean even more production out of OPEC, even more anti-production freeze jawboning, and a return to the same selling that forced Goldman to say on Friday that as of this moment the market is not fundamentally balanced and another bout of liquidation is imminent.
All of this assumes that Pioneer does not change its mind and decide to add rigs a few dollars lower...