Negative Oil Scars Will Linger for Frackers

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But that doesn’t mean frackers can expect to escape the impact of minus-$38 oil completely.

Most obviously, May-day was the prelude to the June contract’s current suffering: It’s under $16 a barrel, and that’s after a big rally on Wednesday morning. Even if it doesn’t eventually settle in the red, there’s a decent chance it will fall as we head into next month. There’s too much oil supply facing too little demand and trying to squeeze into too little storage; hence, the agonizing long-squeeze of April 20. Shut-ins of wells, the last resort for E&P companies, have begun already and will accelerate from here.

Beyond the immediate physical issue, the technical, contract-rolling stuff matters, too. The June contract’s plunge earlier this week was partly due to S&P Global Inc., which runs the biggest commodity index, telling clients to roll quick-smart into the July contract in case the June one ends up mimicking May’s. Not to be outdone, the biggest oil ETF, the United States Oil Fund (NYSE:USO) LP, or USO, announced it too was over June already and would start spreading positions as far out as 12 months forward.

This matters because the futures market is where anyone in the business of producing or using oil comes for insurance against price swings. The fracking boom relied on third-party capital to feed it, and that capital relied on the relative certainty on cash flows afforded by producers hedging their output.

You can’t sell (or short) future barrels if there isn’t someone on the other side willing to go long. Energy economist Philip Verleger noted in a recent report, “Beyond Greed Redux,” that the oil market long had an imbalance of too many commercial operators seeking to hedge and not enough speculators to take the other side of the trade. That changed to some degree in the supercycle of the early 2000s as pension funds piled in, lured by influential research touting commodities’ high returns and portfolio-diversification benefits(1). As returns eroded, exacerbated by the 2008 crash, some traders began to drift away but others, such as hedge funds or individuals tracking indices or using ETFs, stepped up. 

John Hyland, the former chief investment officer for United States Commodity Funds LLC (which runs the USO), recalls that when natural gas prices tanked in 2009, trading of the sister product, the United States Natural Gas Fund LP, soared, stoking concerns similar to today’s around the impact of passive products on price formation. Since then, the gas futures curve has settled at low levels and in persistent contango (seasons aside) — upward-sloping, which is terrible for rolling front-month positions  forward. Activity in the USG has dwindled commensurately.

It’s too early to say if the USO will mimic that. Trading volume has been very high so far this year; annualized, it would be on a par with levels not seen since 2009. However, we are now into our third oil crash in 12 years, and the old bullish narrative of peak oil has given way to murkier considerations of climate change and price wars. Covid-19’s demand shock is an extreme situation, but that doesn’t mean it won’t leave scars. Talking about the recent turmoil, John Lothian, a former commodities trader who now runs his own eponymous financial media business, observes “the public has a bias to the long end [of markets] because prices can only go down to zero. Well guess what?”

While the USO has historically been owned more by institutions than individuals, according to Hyland, as such products rejig positions, they move further away from the original premise of passive money parked at the front end of the futures curve. That makes it harder to know what you are actually buying. Meanwhile, regulators and market managers spooked by negative oil prices may decide to impose constraints of their own.

Hedging isn’t a concern for frackers right now. Hedges cost precious cash; futures are under $40 as far out as 2024; and production has to fall anyway.

But when exploration and production firms eventually seek to stabilize and raise production, hedging will enter the equation once more. As it stands, E&P companies tracked by BloombergNEF had hedged just over a third of their anticipated oil production in 2020 at the start of the year. The corresponding figure for 2021, which is when frackers’ debt maturities start to seriously roll in, was just 3%.

E&P firms tend to hedge further out on the futures curve, so any lasting migration of speculative cash out of near-term contracts might appear to have less of an impact. However, as Professor Craig Pirrong at the University of Houston’s Bauer College of Business points out, spread trades linking near and deferred contracts provide some of that long-dated liquidity. Such trades account for roughly half the open interest of money managers in the Nymex WTI contract.

The cost of hedging may rise as another cohort of speculators learns a hard lesson about futures. Certainly, the lingering glut of inventories and economic damage from the current crisis should keep oil prices low and the curve in contango for a while, suppressing animal spirits.

This may add to a broader theme: a rising cost of capital for fracking and the eclipse of the small, independent model that has long relied on the OPEC put and accommodating financial markets. One day of negative oil prices isn’t an issue for shale. But it may well be a sign of, and catalyst for, fundamental change coming for this industry.

(1) The seminal paper is “Facts and Fantasies about Commodity Futures” by Gary Gorton and K. Geert Rouwenhorst, first published in 2004.

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

Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal’s Heard on the Street column and wrote for the Financial Times’ Lex column. He was also an investment banker.

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