- Open interest in crude futures and options contracts has fallen to a seven-year low.
- OPEC ministers and some analysts believe that the veracity of oil market price signals have been compromised.
- Some pundits are even accusing the Biden administration of fabricating low gas demand data in a bid to hammer oil prices.
In the current month, open interest, or the total number of crude futures and options contracts that have not been settled, fell to a seven-year low, giving rise to OPEC ministerial and analyst concerns that the veracity of oil market price signals has been compromised. Last week, the combined open interest of the four main Brent and WTI contracts fell below 4 billion barrels for the first time since June 2015.
However, analysts at Standard Chartered are not losing sleep over this data. According to the commodity experts, the decline reflects a wider fall in hedging activity due to takeover activity and the bullish outlook of US producers.
StanChart notes that the hedge book has shrunk by 62% since its 2020 peak, and is 35% smaller in the year-to-date thanks mainly to the reluctance of companies to hedge in a rising market. Further, the higher risk held per barrel of open interest due to higher prices has also contributed to the decline in open interest.
Dodgy Demand Data?
Whereas StanChart offers a fairly convincing argument for the sharp fall in activity in the oil futures markets, that has not stopped some observers from hatching several conspiracy theories with some pundits now accusing the Biden administration of fabricating low gas demand data in a bid to hammer oil prices.
To wit, in late June, the EIA shut down reporting for several weeks, ostensibly due to a server malfunction. But as ForexLive has pointed out, gasoline demand data has been consistently bad ever since the EIA returned: "Maybe there's an issue with reporting or maybe it's a conspiracy", ForexLive has declared.
Even Wall Street has begun questioning the EIA data.
Bank of America energy strategist Doug Legate has published a note titled the "fall of gasoline demand appears grossly exaggerated.’’
"For the week ending July 22nd, implied gasoline demand rebounded to 9.2 million b/d - a 1 million b/d increase vs the last two week average, and the second highest level of 2022," BofA wrote in the note to clients. Curiously, the EIA reported a steep drop in gasoline demand shortly thereafter, prompting Piper Sandler global energy strategist to label the data "crooked", saying the methodology left “significant room for error”.
“We are supposed to believe that in July, in the middle of driving season we are only using 8.6 million barrels per day. That would be down half a million barrels a day from May of this year; that would be below the Covid low of 2020,” Sandler noted. “So we ask all the refiners, we ask all the retailers, we ask everybody that reported earnings this season. Every single one of them tells you that their sales are not down materially from even pre-covid days. Some report record high sales,” he added.
Piper Sandler’s allegations are buttressed by U.S. refining giant Valero. Asked about falling gasoline demand at the company’s earnings call last week, CEO Gary Simmons had this to say:
"I can tell you, through our wholesale channel there is really no indication of any demand destruction... In June, we actually set sales records. We read a lot about demand destruction and mobility data showing in that range of 3% to 5% demand destruction. Again, we're not seeing it in our system."
Further, alternate demand data from GasBuddy deviates considerably from EIA’s. GasBuddy tracks retail gasoline demand at the pumps in the U.S. According to GasBuddy, there was a 2% rise in gasoline demand last week, making it the strongest demand of the year. In sharp contrast, the EIA reported a 7.6% drop in demand for the same time period.
The Biden administration certainly is gunning for even lower fuel prices. In an interview with Bloomberg on Tuesday, Amos Hochstein, the White House’s senior adviser for global energy security, said that gas and oil prices need to go even lower while U.S. producers and OPEC+ need to raise output.
But as Adam Button, chief currency analyst at Forexlive, notes, it’s the Biden administration calling the shots now, and “at the end of the day, traders have to trade what’s in front of them”.
"Right now it's a crude chart that's breaking support after a major period of consolidation -- that's not good. The calls for a recession are growing louder crude demand has a long history of following global growth. There are supply factors that will eventually be bullish -- like the SPR releases ending in October -- but that's months away and OPEC is still adding some barrels,” he said.
Where Hedging Is Paying Off
Whereas oil producers are understandably not keen on oil price hedging, the strategy is paying off big time for airlines.
Nearly all of an airline’s costs are somewhat predictable, except one: the short term costs of fuel. Fuel is typically the biggest line item in an airline's expense book, and can account for nearly a third of total operating costs. Two years ago, many large carriers ditched their oil hedges after suffering massive losses due to persistently low oil prices. But with oil prices constantly taking out multi-year highs, they have now been forced to reverse course and are hedging aggressively, with brokers reporting the busiest spell of consumer hedging in years.
Southwest Airlines (NYSE:LUV) and Alaska Airlines (NYSE:ALK) are the only major U.S. carriers that have consistently hedged the cost of jet fuel. Southwest is the only large U.S. airline that is also a low-cost carrier, and fuel accounts for a third of its operating costs. The airline began hedging its fuel costs in the early 1990s after crude prices spiked during the first Gulf War and has religiously hedged through thick and thin.
Southwest aims to hedge at least 50% of its fuel costs each year, and exclusively use call options and call spreads. Company's treasurer, Chris Monroe, and his team trade crude-oil derivatives as a proxy for jet fuel. They deal with some of Wall Street's shrewdest commodity-trading desk including Goldman Sachs, JPMorgan, and seven more traders.
Southwest lost money on its hedges between 2015 and 2017, but this year oil hedges are paying off big-time for the Texas-based carrier.
According to the Financial Times, a crack team of four fuel traders at Southwest Airlines has managed to save the company a whopping $1.2 billion this year through smart hedging. Orchestrated by the company's treasurer, Chris Monroe, and his team, Southwest hedged have slashed its fuel costs by 70 cents to between $3.30 and $3.40 a gallon this quarter, the carrier disclosed in a recent trading update. Southwest has pegged the fair market value of its fuel-derivative contracts for this year at $1.2 billion.
While oil prices have climbed 40% in the year-to-date, middle distillates have seen an even bigger surge: jet fuel recently traded as high as ~$320/b in New York ($7.61/gallon), a massive ~$200+ premium to crude feedstock prices. The jet fuel premium is ~10x larger than any premium seen in the past 30yrs. Southwest’s hedges must have shielded the company from some major price shocks.
"Our fuel hedge is providing excellent protection against rising energy prices and significantly offsets the market price increase in jet fuel in first quarter 2022,"Southwest CFO Tammy Romo said on the carrier's first-quarter earnings call.
Southwest is just one of many companies looking to protect themselves from high oil prices. Over the past few months, there has been a renewed appetite from many airlines as well as an influx of first-timers, including Walt Disney (NYSE:DIS), as well as trucking and manufacturing firms.
“We’re also very fortunate that for the next 12 months, we’re very well hedged on fuel. I would ascribe that more to dumb luck than supremely intelligent management. But nevertheless, we have 80% of our fuel purchased forward out to March 2023 at less than $70 per barrel,” Ryanair Holdings Plc (NASDAQ:RYAAY) CEO Michael O’Leary revealed during the company’s latest earnings call.
To be sure, hedging in the current market can be expensive thanks to red-hot demand for hedging products. Those higher hedging costs have been accentuated by a lack of liquidity in recent months, making it harder to find counterparties and agree on prices. But with oil prices unlikely to come down any time soon, heavy oil users are left with little choice than to hedge or risk paying billions more in extra fuel costs.