The silence of the hedges

Published at 10:28 28 Oct 2019 by . Last edited 12:17 28 Oct 2019.

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We believe three factors could lead to an oil price rally into year-end, despite current bearish sentiment. First, global demand growth has slowed to 0.8–0.9 mb/d y/y, down from 1.6 mb/d in 2015–18, but it is not declining as some think. Key sources of weakness over the past three years—the Middle East and Latin America—are now logging growth, while a ‘Phase One’ deal between the US and China—which could occur at APEC in November—would help China’s economy pick up. Moreover, Q4 19 growth will look stronger y/y thanks to a low base.  

Second, the EIA will next month release US production data for September and October, which we expect to come in lower than some of the lofty expectations that we have seen. Even assuming the EIA’s IP rates are realistic, which is not a given, this suggests growth of 60 thousand b/d per month in the Permian, a fraction of the 0.9 mb/d of Permian-to-USGC pipeline capacity starting up in Q4 19. In short, output will not rise to immediately fill available takeaway capacity.

Finally, political developments could also help oil prices, by reducing US producer hedging and allowing the back of the oil curve to rise. The US financial community is starting to price in the risk, though it is quite low right now, of a presidential election victory for Elizabeth Warren, one of the Democratic frontrunners. In fact, it looks likely that any Democratic president would be a risk to the US shale industry given the growing prominence of environmental issues.

So, for a US oil producer, unless a bank is forcing it to hedge, even the smallest chance of a Warren victory is likely to be a deterrent at a time when the forward curve is already weak. Companies with hedges can be put out of business, as the assets that they have placed hedges against will be worth less. Lower producer hedging (selling) will be the biggest catalyst for an oil rally given the complete dearth of buyers in the market. Pemex has completed its hedges last week.

Fig 1: Regional oil demand, y/y change, mb/d Fig 2: Producer and merchant short positions, K lots
Source: Energy Aspects Source: CFTC, Energy Aspects

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