Smaller oil and gas producers have been major drivers of the US shale boom, and hedging has been critical to financing their operations. But rising production is driving more hedging activity as that market is becoming less liquid, which could mean higher hedging costs for some producers.
“There’s a reason the shale and tight oil booms happened in the US,” said CIBC World Markets head of commodities strategy Katherine Spector at the Columbia University Energy Symposium in late November. “We have a lot of small companies, relatively little guys, independents and small-caps doing this production.”
While larger international oil firms and national oil companies tend to have deeper pockets to finance ongoing development activities, smaller companies often seek to lock in stable revenue streams to fund ongoing operations by selling future production at pre-determined prices, or within bands of prices. “They tend to be much more large, disciplined hedgers of their forward production due to the way their financing is structured,” Spector said.
As US oil and gas production continues to grow, so will producers’ hedging needs.
“Traditionally, North American producers of both oil and gas – particularly US, but also Canadian – have been very consistent and disciplined hedgers of as much as 60-80% of forward production,” Spector told Breaking Energy. “If we are expecting oil and gas production to grow, and if we assume that they’ll continue to hedge the way they’ve aways hedged, that means more hedging.”
“Essentially, our universe of hedgers has been growing and will continue to grow if these North American producers continue to behave more or less as they’ve always behaved with respect to hedging.”
But at the same time that demand for hedging is rising, liquidity in that market is shrinking, Spector said. “This just happens to coincide with a period of time when the liquidity that we used to see provided by some investors in the market, like hedge funds, has really gone down a lot.” She has attributed this to several factors, including rising credit costs, some reduction in risk appetite among banks and hedge funds, and enhanced regulatory scrutiny – and associated compliance costs – for all parties involved in hedging transactions in the wake of the 2008 financial crisis.
“We can see a scenario where the cost of hedging actually goes up for some producers,” Spector said.
But some producers will be hit hard than others, said Spector. “Hedging costs have increased for some clients, as opposed to every single client. A stellar credit client hedging a fairly liquid product like WTI probably hasn’t noticed much difference.”
