On a surreal day late last week, I stopped by the nearest supermarket at what I hoped was a quiet time. I wasn’t expecting serenity, but holy mackerel I wasn’t expecting such an anthill either. While many were shopping in a normal fashion, others were rattled and prepping. Toilet paper was of course long gone. A woman next aisle over piled what looked like about 30 pounds of bananas onto the belt. Another had about ten cans of olives. Panicked weirdos, I muttered to myself, as I hoisted twenty packages of bacon and a few dozen little bottles of Fever Tree tonic water onto the belt. Why people have to go outside their normal shopping boundaries is a complete mystery, but I suppose fear makes people do weird things.
And it really doesn’t get much weirder, or bleaker, than where we are now. The bad news is in many layers. This past weekend, in an overarching environment where the world’s dominant fuel source is under merciless attack, where Canada’s is somehow singled out for even worse criticism, where the world fears for its health and is going into lockdown mode, where two of the world’s oil superpowers combined forces to drive prices to absurdly unprofitable levels, where businesses large and small are getting crushed, where spring holiday plans are being annihilated, where even beloved hockey playoffs are being dismantled, somehow in all this carnage mother nature delivered a kick to the stomach by dropping the thermometer to minus 27, in the middle of March. Why shoppers have chosen to empty toilet paper shelves but not cannabis and liquor stocks is beyond me. Even spring won’t show up, so what possible signs of optimism, other than the usually-true but hard-to-celebrate “I’ve still got my health”, are on the horizon?
Well, there are a few. Most of us do have our health, and we shouldn’t forget that. We also do live in a time where the value of our spectacularly beautiful supply chains is obvious, as is how we take them for granted in normal times. And beyond that, from the perspective of the beleaguered producer and supply chains, there is at least one small reason for hope.
That reason is an odd one, and has to do with a hedging strategy called a three-way-collar. The reason it offers hope is because it is widely used but has an Achilles heel, and Russia and Saudi Arabia may be attacking that weak point. The good news is that if that is true, the oil bloodbath might not last all that long.
What is a three-way-collar? It’s a bit of a complicated hedge but worth understanding since it is important here. Hedging can be done through forward physical sales or product, or by financial means – using financial instruments to simulate actual deliveries. A further derivative of financial hedges is to use options, that is, the right to buy or sell a commodity at a set price for a period of time.
Three-way-collars involve options. A simpler version is called a collar, whereby a producer can protect against downside prices beyond a certain point by giving away upside beyond a certain point. Thus, a collar may be structured such that a producer will receive the market price anywhere between say $45 and $60 WTI; if the price falls below $45, the producer will receive $45, but if it rises above $60, the producer will only get $60.
What makes a three-way-collar interesting and dangerous is that producers opt to sell a third option, which removes downside protection beyond a certain point in exchange for a bit of income from selling the option. In the above example, in addition to the $45-60 collar, a producer might sell a put option at $40 which means any price that falls below $40 will not be protected (better explanation available here).
Three-way-collars are thus dangerous when prices fall precipitously, as they did recently. If oil prices remain within a narrow price band of say $45-55/bbl, then the three-way-collar works well. A month ago, we saw many US shale producers announce their 2020 capital plans which were built on this hedging strategy.
So when oil markets implode like they just did, the protection is gone, and calamity reigns. Many shale companies announced massive capital spending cuts in response, just weeks after announcing moderate ones. Previous capital plans talked about flat or moderately increasing production based on solid cash flow expectations; this past week’s announcements were like howls from a leg-hold trap. Ovintiv’s about-face was the most spectacular; on March 9 they tried to calm panicked markets by stating that they could comfortably “maintain the scale of [their] business”; on March 12 they announced “immediate and significant action” to slash capital spending and drop rigs. Due to three-way-collars, Ovintiv had lost price protection on significant oil sales below $43/bbl and gas sales below $2.25/mcf.
You can safely assume that if I (and others in the wider media stream like Reuters and Bloomberg) have noticed the significance of this second-order meltdown, the Saudis and Russians have figured it out long before. No one understands how to maximize their leverage in the world quite like these two, and their economies depend on how they play their cards (Canada has no spinal fortitude to play this game; we are content with a purple participation ribbon).
It is quite probable then that the Saudis and Russians engineered this price crash to push US shale companies into this danger zone in a forceful way. Everyone suspects that, but this time it was indeed different. Consider how the Saudis played this game in the past. In late 2014, Saudi Arabia drove prices lower by increasing production by half a percent, and a few days later offering discounted crude to key customers. The thesis was that they were comfortable letting prices drift lower in an oversupplied market.
In the 2020 event, the duo, within the span of two days, each announced an oil output strategy that was apparently designed to shock-and-awe the markets, not just guide them. The Russians mused to a Reuters reporter on a Friday that not only would they not reduce oil output to stabilize prices, they would increase it. The very next day, the Saudis announced plans to increase productive capacity (easily confused with actual production by a soundbite-addled media and Saudi’s opaque reporting) up to a startling 12.5 million barrels per day, then an unprecedented 13, and at the same time slashed prices by a significant amount and told the world exactly how much.
Then, the Saudis announced they would book more tankers to help flood the market. Consider that this is all being done in a panicked global environment where demand is falling by an unknown but presumably large amount – air travel is grinding to a halt, industrial activity is slowing, malls are empty, and signs of oil demand destruction are everywhere.
Taken together, these factors reek of a plan by the two wily dictatorships to stun the market into the US shale producers’ red zone. And it’s worked. In the past week, already-reduced capital budgets have been shredded, and producers are vowing to drop rigs at an astonishing rate over the next quarter. (Not everyone shares this view; Rystad Energy consultants issued a bizarre press release stating “Low oil prices? No problem…” where they documented how hedging “gains” (?) could top $17 billion if oil averages US$25 in 2020. Oooh, dare to dream…)
Because of the rapid production decline rates of new shale wells, these slashed budgets may show up rather quickly (as in a number of quarters) as significantly reduced US oil output. And with that masterstroke, the Saudi/Russian duo will have reduced several million barrels per day from the market, and they can (and will) let prices rise to a more comfortable level again but with US shale drillers truly in a bad state. The pair has tried for years to rein in US shale production, and it looks like they may finally have done it.
It’s hard to call that good news, but perhaps it will be like the coronavirus battle. Going into lockdown mode and shutting everything down is the best way to rein in the spread of the virus and end the trauma quickly. Perhaps it will be the same with oil – a quick, brutal decimation of shale capital spending plans that will take years to recover from will set the stage for a return to “normal” prices sooner rather than later.