Backwardation Is The Best Tool For OPEC
OPEC aims to guide global oil prices, and the recent supply cuts to support oil prices post COVID is an example of this. One thing that hasn’t historically been a visible OPEC goal is aiming to coordinate the structure of the oil price curve, and whether future oil prices are higher or lower vs today’s prices, but this may be changing.
There are two trends on the supply side costing OPEC money. The first is the growth of shale over the past several years in excess of demand. Shale production proved resilient in multiple markets and technical advancements combined with cheap capital further accelerated development. The second trend is the refusal of Mexico to cut production and the commitment by Mexico to actually grow future production into a difficult market. Targeting backwardation in the price of oil, where the futures price is lower than the current price, is a tool that OPEC will likely now use against both these market participants.
North American shale companies typically hedge or lock in the future price for a significant percentage of production. Management views it as a prudent way to lock in acceptable returns and many PE owners and shareholders will target an increased percentage of hedged volumes to protect investments from volatility; increasingly important is the fact that many banks ask for it.
Bank loans are secured by a producer’s reserves and the addition of hedges provides a guarantee on the near-term cash flows from those reserves. This makes lenders more comfortable with higher levels of leverage and more willing to provide capital. Backwardation would force producers that hedge to do so at lower future prices. This would reduce the borrowing capacity and would also reduce the ability to get additional debt to backstop larger development projects in the future. Banks would still push for a minimum level of hedging at these lower future prices which would cap cash flows. The aggregate impact for a sector that has to hedge at lower forward prices is less capital for the sector, both internally and externally, which reduces the ability to bring on new production.
Constrained shale supply, and particularly a forward price that doesn’t support long-term investment, is an ideal world for OPEC. In this type of world we are increasingly likely to see large companies acquire production instead of investing in mega projects which will reduce future supply. The constrained capital makes assets more effective within a larger portfolio and allows these deals to be accretive. As a result there will likely be more deals similar to Chevron and Noble, announced yesterday.
During the OPEC+ discussions the most notable and transparent holdout (some countries agree publicly but just keep producing) was Mexico. When asked for a production cut Mexico said no; they were willing to only cut a bit and other countries would have to make up the difference. Excess production is obviously not what OPEC wants, but equally problematic is the dissension it causes. When a country publicly refuses to cut production, other countries start to ask themselves why they are cutting just to benefit Mexico. It is this thought process that leads to quota cheating which can weaken OPEC. One of the things that made COVID more manageable for Mexico is that they hedge a significant percent of their production. This is an annual approach for the Mexican government to ensure a certain government budget. As a result of this program Mexico had already hedged production at higher prices and therefore didn’t have the same urgency as peers. Creating backwardation in the curve structure now makes new hedging less useful for Mexico in future years. Whether specifically meant to target Mexico it will certainly make Mexico’s approach to their oil industry less profitable, which will slow the growth that Mexico has promised.
Trying to impact the forward price curve for oil sounds like a massive undertaking, but there are a few ways to achieve it, and these are very similar to the current OPEC strategy. The first is to shorten the cadence of market decisions to provide more precise control. This is what we now see with OPEC making monthly decisions, compared to historical decisions at six month or yearly intervals. It would then be important to tighten up the spot market by keeping some level of cuts in place, but consistently remind the market that there is significant spare capacity that could be brought back online in the future. This reminder would put downward pressure on the back of the curve and keep future prices lower. The effect would hopefully be that the low future price kept supply constrained but with less financial impact for OPEC as production is sold into a higher near-term market. Across the world people are saying that COVID is a chance to improve on historical practices, and OPEC’s approach to the oil markets is likely no different.