How Derivatives Can Help Navigate the Oil Price Collapse

The greater than 50 percent collapse in oil prices in the last several months caught most of the world by surprise.  It now seems clear that a quick price rebound is unlikely and attention is turning to what a new era of cheap oil means.

As businesses try to assess and manage this new uncertainty, it helps to understand not just the asset correlations but how futures and options can be used as a risk management tool.  This can help deliver certainty on cash flows and reduce the likelihood that an energy shock is going to be terminal for business operations.

As things stand, it appears highly unlikely that we will see a quick return to $100-plus per barrel oil prices and the market is still trying to predict a bottom.  Various investment banks have sharply lowered forecasts, with an average price of $50 a barrel in 2015, and staying close to $60 in 2016. Research and brokerage firm Bernstein forecasts that prices should see a floor at $40 based on the global marginal cash cost for the 50 largest non-OPEC oil and gas companies – or the point at where it is unprofitable to keep wells pumping on a cash basis.

There is no simple answer to how these kinds of prices will impact the oil industry as there is no such thing as a standard oil company.

What we can say is those involved in production will certainly feel pain, although the most dramatic impact will be on companies providing oil services such as exploration and maintenance. There is no doubt that at current prices, activity will be scaled back or put on hold. Indeed, we have already seen some evidence of this with the likes of Schlumberger, Halliburton and Baker Hughes announcing considerable layoffs.

The broader energy sector will also not be immune as cheap oil will feed through to lower gas prices, and intensify competition with other fuels and renewables.

For instance, experience from the recent shale boom in the United States was that it not only drove down gas prices but also had a significant impact on coal mining as they typically compete with each other. Similarly, expect cheaper oil to squeeze the renewable energy industry, such as wind power and solar power. The high price of oil has driven investment on new technologies and innovation in renewables.  We also saw a new global trend develop using gas as transport fuel both in shipping and for heavy trucks and buses. While gas as a transport fuel will continue, the rate of transition will be impacted by lower oil prices.

 

The Global Impact

For most businesses and most people, energy is an expense and they will gain from lower prices. In the U.S., the gains to consumers and companies are equivalent to a $100 billion tax cut according to estimates from Credit Suisse.

For many countries there will be a large wealth transfer between importers facing lower energy bills and oil-producers experiencing lower revenues.  The macroeconomic impact will vary significantly. For example in Asia, Indonesia has been able to cut fuel subsidies thanks to lower oil bills, while in contrast Malaysia has both cut government spending and growth targets due to reduced oil income.

The big oil producing countries will be hit by a write-down in asset values, although the impact may take time to play out.  A lot of the big money in the world is oil driven and this has been a key force behind many property markets in cities such as London.  We may see an impact here or with sovereign wealth funds witha fire-sale in certain assets, even unexpected ones.  For example, Manchester City Football Club is effectively funded by Abu Dhabi oil.

Having considered some of the potential price contagion from the oil price collapse, the question is – how can futures and options help?

While futures and options cannot negate the impact of the price disruption that has already occurred, they can help manage future risk.  Where there is value now, for example, is for the big consumers like airlines, who can hedge against future price rises by going in and buying long-dated futures or options. Likewise, oil producers can guard against further declines.

 

Current conditions have at least been great for liquidity. The recent steep movements in the oil price increased liquidity as many physical hedgers have reached a particular pain point where they have to react and put on new positions. The same is true for money managers, hedge funds or speculators who may reach certain points where they have to liquidate or stop losses as prices move lower. In March, WTI volume rose to nearly 18 million contracts, a 53% increase from a year earlier. NYMEX Brent volume saw an even bigger jump, trading 117% more contracts than in March 2014.

 

New Picture (1)

 

What makes the CME Group derivatives marketplace work so well is that we have a variety of financial participants and commercial firms who have different exposures and strategies.

One key take-away from the recent oil shock is how the severity of the move caught many people in the industry by surprise. The opportunities to hedge were missed. When oil was trading at $105, one could have purchased $80 puts quite cheaply but some companies did not do it, or did not see the need.   If the recent shocks have shown us anything, it is that businesses need protection against them. Whether a price decline or price spike, futures and options are one way to manage risk, and help protect bottom lines.

 

Alan Bannister is Executive Director of Energy Products at CME Group. He is based in Singapore.

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