On the week of March 5th, the OPEC oil ministers met with the Russian oil minister in Vienna for a regularly scheduled meeting of OPEC+, which includes the 13 OPEC members, Russia, and 10 other non-OPEC allies. The objective was to agree on crude oil production cuts that would bolster the price of oil, which fell significantly due to the widening impact of the coronavirus pandemic. A steady increase in border closures, government mandated business shutdowns, and social distancing had prompted a steady decrease in demand for refined products across all sectors; particularly marine, aviation, and vehicle fuel. Unfortunately for OPEC+, and the Kingdom of Saudi Arabia in particular, the distrust between the Russians and Saudis took center stage and the meeting ended in an all-out price war between the Russians and Saudis, with both sides dedicated to maximizing production in an effort to gain market share. This price war, coupled with steady declines in consumption, sent prices for crude and products into a complete free fall, with Brent dropping to its lowest level in 17 years and U.S. wholesale gasoline index trading in the 65 cent per gallon range. Front-month Brent was trading in the $70 range in January, by April 1, the price had fallen to $25.
Many of the oil exporting countries rely on petrodollars to fund their economies, and prices in the $25 to $35 per barrel range leave those governments severely strapped for cash. Therefore, the escalating price war, in the face of a rapidly worsening pandemic, caused global demand for oil to drop 20% to 30% from 100 million barrels per day (bbls/day), which quickly became a crisis situation.
The U.S. oil patch also felt the impacts, as rig operators drilling in the shale formations quickly found that the cost of producing a barrel far outweighed the selling price. President Trump, fearing a collapse of the recently resurgent U.S. energy industry, pushed the Saudis and Russians to end the price war and institute the badly needed production cuts. The President’s bargaining position was weak, as he had minimal ability to offer domestic production cuts since the privately-owned U.S. oil industry is not centrally controlled by the government as it is in most other countries.
Over the April 12 Easter weekend, OPEC+ reached agreement to implement deep production cuts of nearly 9.7 million barrels per day, just under 10% of current production. These cuts were nearly twice the size of the cuts implemented during the 2008 financial crisis. The initial response was a slight recovery in Brent prices to $34/bbl, but within two days prices dropped by almost six dollars as the IEA predicted a 30% drop in April demand that could not possibly be offset by production cuts, with the surplus flowing into storage.
How can companies take advantage of this opportunity?
Notably, these prices reflect the “front month” contract, or barrels slated for delivery in the short term. If your organization has exposure to energy prices, you likely focus more on the longer-dated forward curve, what prices look like six to 18 months into the future. Two changes to the shape of the forward curve stemmed from the current supply/demand imbalance. First, the 24 month forward came down from approximately $57/bbl from beginning of year, to roughly $43/bbl now. Secondly, the market moved from backwardation, where longer-dated prices are lower than prompt prices, to contango, where longer-dated prices are higher than prompt prices. If your organization maintains an oil hedging program, this change in market structure has a meaningful impact when selecting hedging tenors.
Is the oil market functioning efficiently?
Given all of the turmoil in the energy markets and the uncertainty surrounding the pace at which the global economy will “reopen,” with increased demand for refined products and the subsequent recovery in prices, the question of market efficiency with respect to the ability to place hedges becomes the foremost issue. The short answer is “no.” In its current state, the market is not efficient. Liquidity is down significantly; bid/ask spreads are wide; volatility has doubled making purchased options prohibitively expensive; the credit charges levied by banks have increased substantially. Despite the inefficiencies, we have seen quite a few clients take advantage of prices that are near 18-year lows.
How can organizations address current volatility?
Confirm the fuel forecast is still accurate
Due to the recent downward shift in the forward curve, consumer clients that hedged this year’s exposure last year or early this year are likely in an unfavorable position with hedges that are liabilities. Demand for products and services is down globally and many companies, not just airlines and cruise lines, are consuming far less fuel than they forecasted. If the revised fuel forecast remains above the hedged volume and cash flow is not an immediate issue, consider allowing the hedges to unwind over time, as the unfavorable hedge position will be offset by lower prices for physical supply. However, if the hedged volume exceeds the updated forecast or preservation of cash is critical, consider unwinding the current hedges at the strike rate, which will be well above market, and restructuring hedges into 2021 with similar volumes that will also be done well above market, thereby rolling the liabilities back 12 months through a hedge restructuring. You will incur significantly higher bank charges, since the financing for the restructuring will be through the derivatives desk, and this restructuring will also go through high level scrutiny from bank credit desks. Finally, you may need to address hedge accounting considerations stemming from the off-market nature of these restructured trades.
Consider layering in new hedges
Assuming the mid- to long-term fuel forecast can be discerned with a reasonable degree of accuracy, now is an excellent time to lay on additional hedges, despite the fact that the current hedge book may be deep underwater. In 2014, the crude market collapsed, once again due to oversupply, as the Saudis attempted to force the U.S. oil industry to scale back production by driving the price of crude below the cost of production from fracking shale formations. After several years of crude selling in the $100 range, many consumers jumped on the opportunity to add significant volumes as crude fell into the $70 and then $60 range. Unfortunately, it continued to fall further creating huge liabilities. Faced with unfavorable hedge positions once the market bottomed, many consumers opted to avoid additional volume, only to see the market rebound 18 months later, leaving them exposed to rising prices. While this may seem like a suboptimal time to add volume, the market conditions are generally favorable. It is always possible that a prolonged recession could see the forward months fall to the levels where spot is trading today, creating losses on the hedges.
Evaluate the risk in any strategy
The markets are operating in uncharted waters, making risk quantification challenging. Conducting a blend of statistical and scenario analysis enables you to evaluate a series of potential outcomes to help identify the most favorable approach given the uncertainty embedded in the next 12 months. This uncertainty is reflected in market volatility, making a purchased options strategy both costly and difficult to implement due to liquidity constraints. Swaps executed near market lows could quickly become liabilities if the market continues to weaken and the economic recovery is slower than forecasted, leaving your organization over hedged with unfavorable positions on its books. Collars would put bands around future prices and negate the impact of heightened volatility, but may still be difficult to execute given reduced liquidity. To evaluate potential strategies, Chatham recommends creating a multi-dimensional matrix that demonstrates the potential outcomes for a rising or falling market, the time horizon for those prices changes to manifest themselves, and the possibility of an increasing or decreasing fuel forecast.
Socialize the range of potential strategy outcomes
There is absolutely no certainty on how or when the market will respond to the changing supply/demand balance. Those market changes are certain to be dynamic and may reverse course numerous times. While the vast majority of the price activity has impacted the front end of the curve – leaving the middle and back end relatively stable, albeit significantly lower – it is imperative that you communicate the full range of potential outcomes to all stakeholders throughout the organization. Widely disseminating the analysis to gain consensus on the strategy selected and acknowledgement of its risks will prevent 20/20 hindsight in the event of an adverse outcome.
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Chatham Financial corporate treasury advisory
Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with your organization’s objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0128