Energy companies could hedge further weakness in the oil market, potentially fueling downward pressure on oil exchange traded funds.
After oil prices plunged over 45% in the past year, more energy companies are hedging against further declines in the oil market through futures, options and swaps to ensure a certain price for future output, reports Gregory Meyer for the Financial Times.
“Producers don’t want to sell their oil at a cheaper price,” Francisco Blanch, head of commodities research at Bank of America Merrill Lynch, said in the FT article. “[But] it’s not a matter of wanting. It’s a matter of having the choice of waiting or not. If you don’t have the choice to wait, you are going to pull the trigger.”
Consequently, bankers, analysts and industry executives warn that the hedges could add to further pressure on oil futures for delivery in 2016 and 2017.
For instance, a company may purchase a put option with a strike price of $50 per barrel, and if crude oil were to fall below the strike price, the trader would pocket the difference.
The United States Oil Fund (NYSEArca: USO), which tracks West Texas Intermediate crude oil futures, has already declined 13.2% so far this year and plunged 53.4% over the past year. WTI crude oil futures are now trading at around $52.7 per barrel.
If enough companies hedge using this options strategy, the additional bets on falling oil could add to increased pressure on prices. Currently, according to Bank of America, less creditworthy companies have half of their output hedged for 2015, but less than a quarter are hedged for 2016 and 2017, which leaves more room for further downward pressure from hedgers. Simmons & Co. argues that “producers are naked going into 2016.”
These hedges help companies maintain profits credit lines from banks in a falling oil market.
“I think we could see some ‘forced hedging’ by producers to ensure that lenders extend credit,” Virendra Chauhan, oil analyst at Energy Aspects, a consultancy, said in the FT article.
The hedging may have helped energy stocks from declining as much as the underlying oil market. Year-to-date, the Energy Select Sector SPDR (NYSEArca: XLE) fell 5.9%, Vanguard Energy ETF (NYSEArca: VDE) dipped 6.8% and iShares U.S. Energy ETF (NYSEArca: IYE) dropped 6.7%.
However, some larger companies are betting on rising oil prices from here. For instance, ExxonMobil (NYSE: XOM) has minimal hedging of its own production. Continental Resources (NYSE: CLR) even closed out oil hedges last November in hoes of price rebound.
For more information on the oil market, visit our oil category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.