Publications: Notes at the Margin

The Price Anchor: Oil's Almost Two Billion Barrel Hedge (February 3, 2020)


The news came out Friday that the Commodity Futures Trading Commission was raising the limit on speculative positions in futures. Ten years ago, this would have outraged Bernie Sanders. At the time, the senator from Vermont was so convinced that speculators caused the 2007-2008 price increase that he released confidential data on individual firms’ positions in crude. Like the current president, he was never punished for his transgressions.


Today, the change in speculative limits will interest a few reporters. However, it will have no impact on the market because oil producers, as of the end of September 2019, have hedged at least two billion barrels of crude for delivery in 2020. In a few weeks, we will know whether producers took advantage of the brief, end-year price increase to hedge a few million or billion barrels more.


A billion barrels of crude oil matters because total open interest in the three key crude futures contracts at the end of January was only 5.4 million contracts. Thus, on the short side of the ledger, producer hedgers accounted for potentially forty percent of the business. These positions are fixed.


Of course, oil producers do not take short positions in futures. Instead, they buy bespoke puts from banks and other organizations labeled as swap dealers by the commodity regulators. The swap dealers that write these puts will then buy or sell one or two contracts per million barrels hedged, depending on the difference between the strike price negotiated with the client and the actual price. The number of contracts sold in the futures markets will rise (fall) as the spot crude price falls (rises).


The need to sell more aggressively to retain a balanced market position (described as being "delta neutral" by the quants) will depend on the current price and the price negotiated in the swap agreements. In theory, more contracts must be sold as the price falls further below the insurance level (the strike price).


The large hedge position that exists threatens to accelerate any price decline associated with the oil demand worries fanned by the coronavirus spread. Such a decrease could quickly turn into a rout if not offset quickly by OPEC. With the current hedging-related price decline, Brent has already dropped eighteen percent from $69.30 per barrel to $56.70. In a similar 2018 episode, it fell thirty percent from $86 to $50 per barrel.


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