Oil price drivers and the hedging conundrum

Oil price drivers and the hedging conundrum

Lionel Kruger Weekly bulletin August 2018

The oil bulls have enjoyed a great run this year, with Brent Crude peaking at just under $80 per barrel in May and making another strong push in July. A number of factors continue to support the outlook for the bulls, but the current Emerging Markets sell-off resulting from the spectacular collapse in the Turkish Lira is posing some questions for them. Added to the EM action are Trump’s trade war activities, which have the potential to reduce global growth and, accordingly, demand for oil. EM contagion notwithstanding, I think the potential for higher oil prices remains supported by some key fundamentals:

  1. Trump’s sanctions against Iran have kicked off with the US beginning to implement the necessary actions and intending to target Iran’s petroleum sector from November. Trump is bringing increasing pressure on all countries to comply with the US position, stating, “If you trade with them, you won’t trade with us!” Iran is the third largest OPEC producer, supplying just short of 4 million barrels per day. In addition to Iran’s supply contribution, it is strategically positioned with regard to the Strait of Hormuz, which is a potential chokepoint for 30% of global oil exports. Iran is threatening to stop ships from passing through the Strait if the US succeeds in halting crude sales from the Persian Gulf nation.
  2. Venezuela’s oil crisis continues to worsen as production keeps falling. Supply has already dropped by 800 000 barrels per day from a year ago with no sign of a respite in sight. As the economy grinds to a halt, oil supply will be choked off.
  3. The fact that the oil industry is facing the largest squeeze on its spare production capacity in more than three decades. Spare capacity is the extra production that oil-producing states can bring on stream and sustain at short notice, providing global markets with a cushion in the event of a natural disaster, conflict or any other unplanned supply outage.
  4. Geopolitical risks within the Middle East: these remain a constant threat to supply as Iran and Saudi Arabia continue to square up against each other. Any unilateral action by Iran in the Strait of Hormuz would almost certainly raise the spectre of a retaliation from Saudi Arabia.
  5. Global growth outlook, which appears to be shrugging off any effects of rising tariffs and is supportive of higher oil prices.

Whichever camp you find yourself in, bull or bear, the risks of higher oil prices remain a very real threat to consumers and the energy complex offers some interesting opportunities to take out longer dated hedges, especially following the latest pullback in prices.

One sector for which this is particularly relevant is shipping, and specifically because of an impending change to emissions standards that will see the industry being forced to adopt the International Maritime Organisation’s (IMO) 0.5% global sulphur cap. Those of us living in Europe have enjoyed extremely hot weather over the past few weeks and should roundly support this initiative. The global shipping industry accounts for approximately 5% of global oil demand and is arguably responsible for as much as 40% of all oil-based sulphur emissions. Accordingly, the IMO has taken it upon itself to ensure that the shipping industry adapts its behaviour to fall in line with other industries and target cleaner emissions.

Annual marine fuel consumption in all grades is in excess of 300 million metric tonnes per annum, with approximately two thirds of this consumption thought to be exceeding the low sulphur cap. The industry will be forced to comply with the low sulphur cap from 01 January 2020, and this could lead to a change in the forward pricing curves for the affected products such as Marine Gasoil (MGO), Very Low Sulphur Fuel Oil (VLSFO) and High Sulphur Fuel Oil (HSFO) as demand shifts. This change creates hedging opportunities, and when combined with forward FX strips can create low forward strikes for hedging purposes in non-USD currencies. The GBP in particular offers such an opportunity, firstly due to the positive carry against the USD and secondly because the currency looks likely to suffer significant volatility in the lead up to the fateful deadline for a Brexit deal on 29 March 2019.

Upcoming economic releases

This week is a relatively light week on the data front as the northern hemisphere summer continues in full swing. Markets are likely to be dominated by the unfolding crisis in Turkey and a possible sovereign default.


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