Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

OPEC is having a reasonably good week. Brent crude oil edged above $53 a barrel on Thursday for the first time since late May, in part because the organization raised demand projections in its latest monthly report. The day before, U.S. oil inventories data showed another big drop (for crude oil anyway), and that came after a week in which second-quarter results betrayed some signs of strain among those pesky Permian types.

Hovering over this late-summer cheer, however, is a troubling question for OPEC: Can it expect anything more than "reasonably good" in the near term?

Another price-marker that has edged up this week is Bloomberg's fair value for crude-oil swaps in 2018, essentially an indication of where future barrels are trading hands for the next calendar year. This has now traded above $50 a barrel for five sessions in a row; also the first time that's happened since late May.

This is important because U.S. shale producers rely to a significant degree on hedging future production. Locking in prices locks in some certainty on cash flow, which keeps bankers onside and drilling budgets on-track, a consideration that has become especially important since oil crashed, beginning in late 2014.

Indeed, if you look at the level of hedging activity by E&P companies, a pattern emerges. This chart shows the net short position of swap dealers in Nymex crude-oil futures and options, a proxy for hedging activity (E&P firms generally use swaps dealers). The lower the number, the more oil sold short, or hedged. 

Planting Season
E&P firms have rediscovered their appetite for hedging as forward oil prices have recovered somewhat from the crash
Source: Bloomberg

That chart is the mirror image of this one showing the rolling average for the next 12 months of oil futures prices:

Fifty Sense
Since oil prices bottomed out in early 2016, U.S. E&P firms have tended to hedge more barrels when forward prices rise above $50 a barrel
Source: Bloomberg

This tension around the $50 mark is OPEC's biggest headache. As I noted here back in March, the magic number for U.S. E&P firms likely lies somewhere between $50 and $65 a barrel. In that range, many of them can fund production growth without trashing their balance sheets.

So as OPEC does its part to drain inventories and reignite a rally, it must ask itself how good is too good when it comes to oil prices? An increase in cash prices helps OPEC members because that's how they sell their oil and earn cash to support their struggling petro-economies. But if forward prices rise along with them, that's where the shale players play, and they will take the opportunity to hedge -- which helps fund the drilling that eventually takes the wind out of the market.

Speculative interest -- as indicated by the net positioning of managed money accounts-- has picked up again of late:

Feeling Groovy
Speculative positioning in oil has become more bullish of late
Source: Bloomberg

However, a lot of that move reflects short positions being closed out after a spike in late June. OPEC can count that squeeze as another victory.

To make it really count, though, it'll require some genuine enthusiasm on the part of speculators. That's a tough ask, given that the oil bulls just lost one of their most high-profile members (legendary trader Andy "God" Hall) and the end of summer (and the beginning of refinery maintenance season) is just around the corner.

And, of course, any rally will face pressure from those hedgers in Texas. For oil prices to break out of that pattern, the impetus may come, perhaps violently and tragically, from another big oil producer further south.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net