What the surge in oil-basis hedges tells us about Permian operators

And what it means for projects due to start in 2019

1 minute read

Permian producers increased their 2020 oil-basis hedge positions by 431% in Q2 2018, according to Wood Mackenzie's latest analysis of oil and gas hedging activity. This surge in oil-basis hedges signals concerns by producers that key pipeline projects may fail to start up by their 2019 target dates.

It was an anomalously high trading volume for this particular hedging derivative [2020 Mid-Cush basis-swaps]. The only reasonable conclusion one can draw from this surge is that Permian producers are concerned that key pipeline projects won't be completed on schedule.

Andrew McConn, Principal Analyst, Corporate Research

With oil production forecast to grow more than 400 thousand barrels per day year-over-year on average through 2022, Permian Basin oil production is running at a breakneck speed. This surge in production is overwhelming the basin’s takeaway capacity and causing oil and gas to sell inside the basin at steep discounts to national indexes.

As recently as 2015, significant pipeline capacity constraints caused the Midland to Cushing WTI discount to widen to $20 per barrel. This has prompted many Permian operators use derivatives to hedge against the risk of price differentials growing wider.

While midstream operators are racing to complete pipeline projects and expansions to help ease congestion, it could take more than a year before producers in West Texas see sustained relief. Indeed, current under-construction of final investment decision (FID) projects will not provide sufficient capacity until  late 2019, Wood Mackenzie estimates.

The increase in 2019 Mid-Cush hedge positions (+52%)] suggests that producers perceive risk for that year, as well. Specifically, the risk that Midland oil prices don't gradually rise and converge back to parity with the Cushing index – as futures markets currently imply.

Andrew McConn, Principal Analyst, Corporate Research

While infrastructure might have lost the race with production in 2018 a massive build out in late 2019 could flip that script. According to Wood Mackenzie's latest North American Crude Markets short-term outlook, more than 2 million barrels per day of capacity is slated to come online beginning in late 2019/early 2020 which will send the basin into a temporary medium term over build.

As new pipelines flood the basin and excess capacity provides a cheaper route to the US Gulf Coast market, Midland crude prices could shift from massive discounts to Cushing to slight premium pricing.

John Coleman, Senior Analyst, North American crude oil markets

We forecast potential for approximately 1.5 million barrels per day of excess pipeline capacity in late 2020. This will have ripple effects on basin pricing for years to come with expected downward pressure on pipeline tariffs showing up in basin differentials well into the early 2020s. 

Elsewhere, oil-hedging grows cautiously; gas-hedging plummets

Our global analysis indicates that producers used the higher price environment as an opportunity to protect volumes against price risk (mostly in 2019). The average strike price was the highest we have seen in any quarter since doing the analysis. But producers were careful not to get too excited. Volume was far from the Q3 2017 high, when producers rushed to hedge at the beginning of the oil-price rally. Find out more about latest oil and gas hedging activity across the globe  fill in the form at the top of the page to get your free copy of the report.