It is striking to see Brent just about holding the $60/bbl line with all the recent outages and geopolitical headlines hitting the tape.
An extension of concerted cuts from OPEC+ with officials talking the market up, higher US equity markets and median analyst estimates $10/bbl above the forward curve, and yet Brent cannot trade higher.
Geopolitical tension, a pipeline explosion deep into Saudi, tankers sabotaged and a build-up of US military personnel setup for confrontation with Iran, would, at almost any other moment, have caused a pop in oil prices. Now nothing…
The market is telling us something: thanks to trade wars, it is re-pricing demand growth as it perceives China to dwarf everything else for the sector. Whether this is totally accurate or not, might be missing the point.
Perceptions here are important. Fear that escalating trade wars can be a game changer is being priced in across the commodity landscape – one must pay attention as sentiment shifts of that nature can be self-reinforcing (Soros’ “theory of reflexivity”, a pattern he observed years ago seems fitting).
For oil producers’ hedge books, new revised target levels and adapting structures are necessary as value has shifted in the derivatives market from one extreme to another.
BIGGER THAN FUNDAMENTALS
Saudi Energy Minister Khalid al-Falih comments, earlier in March, to steer Brent into the $70-$80 range fell flat as oil prices dipped briefly below $60/bbl. Price makes the news, at least at this moment, and perceptions are everything.
In this context, one of the main issues has to do with the unwinding of long positions: specifically for momentum-driven funds long positions.
Our model replicating buy/sell signals flipped on a short-term and medium-term basis to sell in early June.
If the Brent price flatlines over the next week or two, the long-term core signals would trigger a sell signal by the end of the month (purely on deteriorating price momentum).
That would be 3 out of 3 and these funds will start to pile in short positions aggressively. This must be monitored as the volume can be colossal for the paper market.
A U-turn from max long to max short is the equivalent of establishing a 700 – 800 mbbls short position by our calculation.
It would not be hard to then picture a self-reinforcing negative spiral where lower energy prices are perceived to be pointing to lower demand, to oversupplied future balances, which in turn affects sentiment negatively.
Put another way, Brent must pull higher in the coming trading sessions so that it does not trigger a significant wave of additional (machine-driven) selling.
WHAT IS THE HEDGING AND DERIVATIVE ACTIVITY POINTING TO?
Market participants are paying up for protection as uncertainty has set in.
- Producers, apart from a few specific deals, are largely absent from the market and active players tend to be net premium (i.e. volatility) buyers.
- Consumers, specifically transportation companies, are active in Brent and refine products (buying against investor and momentum-fund selling). This is also net volatility buying hedging flows.
- “Tail-risk” is also being hedged by investors, buying deep-out-of-the-money puts / calls on trade war escalation or as a hedge against geopolitical risk.
The net result is that implied volatility for oil is very high in the derivatives market, and not just for nearby maturities, but across the board.
The other consequences for producer hedging, is that put premium (i.e. put skew) is also at very high levels. This increases hedging cost by $0.70-$1.00/bbl on a put volatility skew basis only for a standard producer collar structure. There are hedging structures that monetise and take advantage of this “derivative dislocation” and producers need to adapt.
BRENT 1Yr Chart | Red = Brent price, Light Blue = Implied volatility & Dark Blue = put premium
MEXICO SOVEREIGN HEDGE
We have done an analysis of Mexico’s annual hedging for over a decade’s worth of data and the results are interesting:
Despite paying $1bn+ in premium every year, the hedge is considered very successful as it has been profitable over time as a few negative years ripped huge rewards, specifically 2009, 2015 and 2016. The hedge is by far the biggest commodities hedge and the entire market is on the lookout for that flow.
Usually by May/June timeframe, you would expect at least a large volume to be placed but this year it seems to have been postponed or put on hold.
A combination of factors could make the Mexico hedge particularly unattractive this time around:
• First, Mexico’s Maya crude (a heavier grade than WTI and Brent) trades at a premium to WTI, which is very unusual. Unusual but understandable considering the US sanctions placed on Venezuela and Iran, both significant heavy oil producers.
• Second, counterparts taking on the hedge have to replicate the exposure, in the most liquid way possible for risk management.
One leg represents the Maya crude performance, which Mexico is hedging. The second leg must be recreated in the derivatives market where the counterparts aim to replicate the Maya grade by hedging via a basket of light sweet crude oil and fuel oil components.
• However, the fuel oil market is undergoing severe changes itself and historical market dynamics may no longer apply. New, stricter sulphur regulation by the International Maritime Organization (IMO) has potentially game changing consequences for fuel oil and high sulphur, heavy crude oil.
Trading firms may therefore have exceptional difficulty offsetting this risk exposure, which may cause some difficulty for Mexico to hedge its Maya exposure.
IEA, EIA, OPEC supply/demand forecasts (Averaged)
HARD TO RECALL A MARKET WITH THIS LEVEL OF UNCERTAINTY
An incessant spurt of bullish headlines from officials (OPEC+ and oil ministers) and constructive sell-side research (“things will be better”, “demand not that bad”) and yet Brent keeps trading lower – nor does it trade below the $60/bbl line. Looking at the median analyst forecast, the street is forecasting Brent at $70/bbl for 3Q & 4Q 2019, that is ~ $10/bbl above the current forward curve.
The oil market is trapped between two huge game-changing variables it is trying to assess.
• Geopolitical risks: We certainly recall a time when geopolitical tension was a dominant driver for oil prices. A military build-up towards confrontation, missiles and drones with precision targeting Saudi Aramco oil infrastructure, bombs placed on oil tankers, the Strait of Hormuz threatened to be closed, oil is $100/bbl you would think? But no, oil is down to $60/bbl.
In fact, even the backend of the forward curve is below the $60-$65/bbl level, seen as the marginal cost of supply, example Brent CAL 2022 is trading $58/bbl.
• US-China Trade Wars & Demand: The market is going through a re-pricing of China demand growth expectations.
Last year for instance, the bulk of demand growth (60%+) came from only two countries: US and China. It makes US-China trade wars by far the most important variable to watch. Analysts can model their supply/demand balances but the market sees it another way.
Of course, the US oil liquids growth and debottlenecking of Permian crude to the seaborn market means there is “less upside explosivity” and more cushioning.
Still, what does the current market tell us about demand? The market lost roughly 2.2-2.5 mil bpd in the past 1.5yrs from Venezuela and Iran alone and yet prices trade lower.
IEA, EIA, OPEC 2019 demand growth forecasts (mb/d) | Source Morgan Stanley
The result is a market with huge uncertainty desperate to go either way.
This is reflected nowhere better than in the derivatives market where Brent implied volatility is at 40% and is pricing a high/low movement of at least $1.5/bbl per day. Oil market participants have to price in geopolitics, trade wars and President Trump’s tweets on top of oil specific variables and this is no easy process at the moment.
For producers, structures should be re-calibrated – as there is arguably unquantifiable upside risk- and yet hedge trigger levels lowered.
We provide unbiased market, derivative & risk-management advice. Contact us to discuss further implications and optimal hedging strategies contact@comtradingcorp.com
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Commodities Trading Corporation is a London-based private advisory company specialized in commodity risk-management, hedging & trading. We service a growing need in the natural resources sector for unbiased and strong expertise and provide our services to an array of corporate clients and financial institutions. We are experts in derivatives and monetizing volatility and develop corporate strategies for hedging energy portfolios, using bespoke derivatives solutions for price risk mitigation.
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