Mind the dip: how hedging cushioned the blow when oil prices fell through the floor

Pritesh Ruparel
August 18, 2021 | Hedging Insights

Mind the dip: how hedging cushioned the blow when oil prices fell through the floor

It’s tough to pick the most jaw-dropping moment of 2020 — a year that’ll be remembered for a constant stream of jaw-droppers.

 

But if you forced us to pick, we’d choose April 20: the day oil prices went negative.

 

Oil is critical to the world economy. It powers our industries, fuels the vehicles that bring us food and other essentials, and keeps our homes warm on cold winter days (and cool when the sun gets overzealous).

 

Yet, on this fateful day, its price collapsed to -$37.63 a barrel. Which means oil producers had to pay people to take it off their hands, instead of the other way round.

 

The madness only lasted a few hours. By the next trading day, oil cost money again (though, at $5 a barrel, buyers were still getting — to borrow 2020’s catchphrase — an unprecedented bargain).

 

That said, the repercussions of this crash are still being felt. And those who chose the wrong hedging strategy are bearing the brunt of the damage.

 

This is the story of how this historic collapse happened, and what it teaches us about hedging.

A continuous rollercoaster

-$37.63 a barrel may be the lowest price ever recorded in the history of oil prices being recorded, but it’s hardly the first time oil prices made headlines. The price of oil is infamously volatile, and sharp fluctuations have sent shockwaves through the world economy countless times throughout history.

 

In 1973, for instance, the price of oil shot up by 300% and triggered a global economic crisis.

 

More recently, in 2016, low oil prices sent Venezuela’s economy into a tailspin and made their currency about as valuable as toilet paper.

 

As with other commodities, the price of oil largely follows the laws of supply and demand. When oil supplies are plentiful and demand is low, oil is cheap. And when demand is high and supplies are low, its price goes up.

 

The problem is that the supply of and demand for oil are highly susceptible to complex, interrelated factors.

 

And that’s what makes it so volatile.

What's up with the price of oil?

There are five main factors that affect oil supplies:

 

  1. The nature of oil
  2. Production costs
  3. Environmental factors
  4. Geopolitics
  5. Changes in demand

Oil is a finite resource

BP reckons that, at the end of 2020, there were around 1,732 billion barrels of proven oil reserves — enough to last us around 53 years at current rates of consumption.

 

Oil companies are continually looking for new sources and developing technologies to make exploration more efficient and likely to bear results. When the US developed the technology for drilling into shale rock, for instance, production soared, which caused oil prices to drop.

 

But oil exploration is expensive, and there are no guarantees. Plus, there are environmental and ethical concerns. Fracking, for instance, is highly controversial.

Turning oil into a useable resource

Finding oil is only one piece of the puzzle. Before we can use it for fuel and heat, it must be extracted, transported to refineries, and processed.

 

Needless to say, the practicalities of doing so influence supply, which in turn affects the price.

 

In the Middle East, for instance, oil is relatively cheap to produce. But as we use up these sources and increase our reliance on oil from regions where extraction costs more, prices will likely go up.

 

Similarly, if transporting, storing, and forwarding oil to buyers becomes more difficult, for example because a key link in the supply chain is in a war zone, this will affect supply.

Bad weather

Drilling for oil is an outdoor activity. And that means oil producers are at the mercy of the elements. When environmental conditions are good, production goes smoothly. But if they turn bad, it can slow down production or stop it completely, which impacts supply.

 

Case in point, in 2005 hurricanes Katrina and Rita destroyed 115 oil platforms along the US Gulf Coast, damaged 52 others, and shut down production for weeks. As a result, oil prices became 50% more expensive compared to the previous year.

Playing politics

Because oil is such a crucial resource, politics plays a huge role in shaping supply and demand.

 

There are countless examples of nations using their status as oil producers as a political weapon.

 

We’ll give you two.

 

When oil prices hit record highs in 1973, it was because the members of OAPEC — the international organisation of Arab petroleum-exporting countries — decided to stop selling oil to countries they considered too friendly towards Israel.

 

And in 2014, Saudi Arabia started selling oil at discounted rates to drive the price down and make life more difficult for US shale oil producers.

Demand shapes supply

The last factor in the demand-supply equation is demand itself.

 

Oil is important for many industries. So when economies are booming, demand for it increases.

 

By contrast, when economies slow down, demand for oil decreases.

 

Similarly, demand for oil decreases when the weather is mild and increases when it’s unusually cold or there’s a heatwave, because we use more energy to heat our homes or crank up the air conditioning.

20/04/2020: A cataclysmically large, brown mass hits an industrial-sized fan at hyperspeed

Any of these five factors on its own could send oil prices into the stratosphere or rip the bottom out of the proverbial barrel.

 

But in 2020, the unthinkable happened: everything went wrong at once.

 

When the WHO declared Covid-19 a global pandemic in March, oil prices got caught in a downward spiral.

 

Lockdowns and other restrictions on face-to-face interactions meant people were traveling much less (or not at all), factories greatly reduced or shut down production, and the amount of freight decreased. So demand for oil collapsed.

 

At the same time, Saudi Arabia decided it was a good idea to show Russia who’s boss. When Russia refused to cut production in the face of lower demand because of the pandemic, Saudi Arabia flooded the market with cheap oil.

 

At this point, supply exceeded demand by so much that the world was in danger of running out of storage space.

 

But the final lid on the barrel came in the form of market speculation.

 

With oil prices on a downward trajectory, traders started betting that the price of oil would continue to fall. Their trading activity created a self-fulfilling prophecy — it kept pushing the price of oil down further until it went negative.

 

A word to the wise: how you hedge matters as much as hedging itself

While oil prices didn’t stay negative for long, they remained volatile because of the uncertainty created by the pandemic. So oil producers rushed to hedge in order to protect their revenue.

 

In principle, this was a good idea.

 

Hedging guaranteed they’d sell a certain volume of barrels at a specific price. Knowing a set amount of revenue is coming in means you can plan production ahead of time and budget for exploration and research and development.

 

But what many oil producers failed to realise is that how you hedge is just as important as hedging itself.

 

Oil hedging is typically done through options, forwards, futures and swaps.

 

An option is an agreement to sell X barrels of oil for a specific price at a set date in the future. But it gives you a choice. There’s a right — but not an obligation — to sell. So you can disregard the agreement if the market price is better.

 

The catch is that you need to pay an upfront premium to lock in the rate.

 

Forwards are also agreements to buy and sell X barrels of oil for a set price at a future date. But, unlike options, they create a legal obligation. So while you don’t need to pay a premium to lock in the rate, the trade-off is that you have to honour the contract regardless of whether the price you’ve locked in is better or worse than the market price.

 

Unfortunately, many oil producers felt very pessimistic about oil’s medium-term prospects, and hedged using forward contracts that locked in low rates.

 

So once the Saudi Arabia-Russia spat quieted down, the worst of the pandemic was over, and oil prices rallied, oil producers had to honour unfavourable agreements. Which meant they found themselves gushing money to the tune of $10 billion.

 

In the words of IHS Markit’s Raoul LeBlanc: ‘If you misunderstand this [hedging] you will be hammered… They [oil producers] missed the boat this year.

 

So here’s the moral of the story.

 

If you’re dealing in a volatile commodity, it’s wise to hedge.

 

But when things are extremely uncertain, you’re best served if you keep your options open.

 

Markets are predictably unpredictable.

 

Find out how Assure Hedge can help your business hedge affordably, with zero effort.

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Pritesh Ruparel