Crude Prices, Hedging, and Missing the Forest for the Trees

John Dizard has written an important opinion piece for the Financial Times, entitled “Much of the investing public will be sacrificed to the oil-money gods.” As headlines go, this one may be a challenge to parse. But the piece is well worth reading, as it articulates some disconcerting assessments of what the oil price collapse could mean for energy markets and the global economy. Namely, Dizard mentions that financial markets are currently on a razor’s edge, and many experts—most recently and most notably Jamie Dimon of JP Morgan—believe we are on the brink of another major credit lockdown, although nobody is sure exactly what the “trigger event” will look like. Dizard thinks it will be oil prices, noting that the commodity’s 50 percent drop since last summer has resulted in relatively few bankruptcies in the highly leveraged oil industry, only some restructurings and mergers. Although the rig count has fallen, production has not. Furthermore, most petroleum economists see oil prices remaining above $50 per barrel, and generally trending back towards $100 per barrel in the medium term. So what’s the problem? Dizard asks, “When has there ever been a bottom put into a market when inventories have not been liquidated, and when there have been no spectacular bankruptcies? Answer: never.” Oil producers, particularly in the shale patch, are pushing forward with production, due to their high levels of debt to service. But as each individual producer races to pump enough oil to meet their own bottom lines, and production outstrips demand, we could see prices track lower into the $30 and $40 range. This could be the point when oil companies begin defaulting on the trillions of dollars of debt that have propped up the shale oil boom, with untold consequences for the market. Don't be surprised if all this is giving you déjà-vu of the 2008 financial crisis. Dizard’s take is partially corroborated by a Bloomberg story from last week about the oil industry’s “$26 billion life raft,” which cautions that many of the same Wall Street firms that have been financing the oil boom are now on the hook for price hedges. The Wall Street Journal reports that many oil companies have locked in oil prices at $91 per barrel, and cashed out their hedges in advance. One company, Carrizo Oil and Gas, pulled in $166.4 million from its hedges on some 12,100 barrels per day of production—more than the company’s entire revenue last quarter. This practice has two disconcerting impacts. First, it could be keeping companies drilling even when their marginal production costs have fallen below the market price of oil. The windfall that comes with cashing out a hedge may be insufficient to sustain business in the longer term, and can leave companies more vulnerable if prices dip again further down the line. For example, Continental Resources cashed out its oil hedges when crude was priced at roughly $80 per barrel in early November. The company’s board unanimously approved the move, which earned the company $433 million at the time. However, the company left untold millions on the table by cashing out when it did, before prices really started to tumble. The company’s CEO Harold Hamm has said, “That wasn’t when we needed the money. We need it now.” When oil companies don’t cash out their hedges, there’s also the issue of who covers the difference when the company is locked in at $90 per barrel or higher, but spot prices are in the $50 range. Banks have sold a great deal of those hedges to third parties, most of which are not disclosed to the SEC or any other regulatory authority. In addition to being on the hook for that risk, many of these banks sold insurance to oil producers against low oil prices, to the tune of $26 billion as of December 31. These insurance policies might help many oil producing companies avoid bankruptcy, at least for now, but they represent a significant liability for the financial services industry. The Bloomberg piece clarifies, regarding the $26 billion, “These aren’t, of course, the kind of figures that would trigger any sort of systemic-risk concerns,” noting that major banks hold trillions of dollars in total assets. Perhaps, though, they find themselves only looking at a tree in the forest of debt and liability that Dizard describes.