Before last year oil price crash in 2014, many oil producers bought insurance on their selling price of crude oil at approximately $90 or more, most above $100 per barrel. This was to protect oil companies from oil price shocks like the one the world suffered in the past year. Now this insurance is expiring this year.
Maybe this year is what OPEC is waiting for. The year where majority of the oil price protection would give way, and many oil companies, particularly the smaller ones, would be vulnerable to the low oil prices. We can imagine OPEC eagerly waiting for this moment where many of the shale oil producers start to fail and disappear from the market, enabling OPEC to consolidate further market share from the US producers, while enduring low oil prices which were hurting their country's economic budgets. But it is probably worth it, as they renewed their efforts to continue pumping supply into the market even at depressed prices.
The purpose of buying such hedges was not so much of the protection of the margins, but more of the buying of time for these shale oil producers. The transfer of risk to counterparties has allowed producers to focus on cutting costs and on more efficient oil-producing regions before the day of reckoning is about to begin. For many companies, this allowed them time to cut back on the number of oil-producing assets, particularly the inefficient ones, which were more vulnerable to the tighter margins that is to come.
For oil exploration company SandRidge Energy Inc, the protection from such hedges was so crucial that it had made up at least a whopping 60% of the company's income for the quarter!
Now with the insurance expiring this year, such oil producers could buy insurance at the current price of around $50 per barrel, which may not make sense, unless the oil prices continue to decline. Or perhaps they may not protect against the prices, and focus on delivering profits on the already squeezed margins. Whatever the decision made, the true test for oil companies is beginning to unfold.
Some oil companies may, however, continue with hedges, as they see it as a form of insurance and part of the business costs, to protect from sudden shocks of the oil market.
Unfortunately, the situation may be about to get worse. With the hedges expiring, the risk grows and creditors would be much more cautious when it comes to lending more debt to oil companies, particularly so since it is likely oil producers would be facing a tighter cash-flow from then onwards. This is a double whammy for shale oil producers, which may need not just fight for margins and market share in the already weak oil market, they have to contend with the tighter credit lifeline.