ANALYSIS: Weak oil prices reinforced through steeper light sweet discounts, options hedging

Many analysts have chalked up the recent weakness in prompt oil futures to a stronger dollar, weakening global demand and unabated supply length due to the US shale revolution. And even as some wonder if sustained lower prices will impact long-term North American production levels, others point out that US light sweet crudes will likely need further discounts if they are going to make it to the markets best suited to run these crudes. Further, producer and market maker hedging in both ICE and NYMEX crude options markets have also reinforced the drop.

Despite market "fears" that lower prices could shut-in the more expensive US domestic crude production, Barclays analysts Friday saw further discounts needed if light sweet US barrels are going to make it to markets that are best suited to run them, assuming an option to export them remains off limits. "As domestic crude begins to mount at the Gulf Coast, we expect sellers to discount their barrels to ensure that they get shipped, processed or stored," they said in a Friday note. Light sweet barrels could displace heavier crudes on the USGC, the analysts said, but that is highly unlikely due to the build-out of cokers in the region. This leaves railing or shipping the crude on Jones Act tankers to either the East or West Coast. And in order to compete with imports in these regions, producers will have to increase discounts.

As Platts reported this week, more West Texas Eagle Ford is moving toward refineries in Canada and the US Atlantic Coast. So far this year an average of more than 42,000 b/d of crude went to Suncor, Valero and Irving Oil refineries in Eastern Canada. About 35,000 b/d likely went to the 330,000 b/d Philadelphia Energy Solutions plant, the largest on the USAC. Refining margin data on the USGC favors coking. Coking margins for West Texas Sour are over $14/b on a 30-day moving average. LLS coking margins are around $13/b over a similar period. By comparison, margins for imported Kuwait are just under $8/b.

USGC cracking margins for Eagle Ford, meanwhile, are just $7.56/b on a 30-day moving average. Cracking margins for North Dakota Bakken -- which has long held a presence on the US Atlantic Coast -- have averaged $9/b over the past 30 days, even after factoring in rail costs. Platts margin data reflects the difference between a crude's netback and its spot price. Netbacks are based on crude yields, which are calculated by applying Platts product price assessments to yield formulas designed by Turner, Mason & Co. After factoring rail, port handling fees and Jones Act shipping rates, Platts data shows that Eagle Ford producers would have to greatly discount their crude if they wanted to compete in the US Atlantic Coast market. While delivered Bakken would have cost around $94/b over the past 30 days, Canadian Hibernia would have cost around $90/b. Bonny Light would have cost around $93/b. But Eagle Ford, based on Platts Eagle Ford Marker assessments, would have cost around $100/b after including shipping costs.

OPTIONS HEDGING SUPPORTS SELLOFF It is a well-established market dynamic that crude producers will use options as a mechanism to help lock in a floor to prices. As the price of the underlying crude contract falls through key strike prices, put options are exercised in order to staunch the impact of a weaker market. By comparison, in a rising market, refiners -- naturally short crude oil -- will often go long call options in order to lock in a ceiling to prices. NYMEX December $75 puts have been very active over the past three weeks, with volume averaging around 4,300 lots/day. Open interest for December options is typically elevated, but it has held above 30,000 contracts for the $75 put over this time period. This is up from around 25,000 contracts over the first 10 day of October. Likewise for $75 December Brent puts, which saw activity perk up last week. Open interest in the bearish $75 put was over 20,000 lots Thursday after having been steady around 18,500 lots since mid-June. Morgan Stanley analysts Adam Longson and Elizabeth Volynsky said in a Thursday note that the last $10/b of downside movement in Brent prices was likely due to financial impacts, rather than bearish fundamentals. They pointed out that as the price of crude has fallen, put options have gained in value while call values have fallen.

"While macro funds sold commodities on USD strength and economic concerns (coupled with fears about OPEC), producer hedging and the related risk management of option exposure from dealers has only added to the selling pressure in recent weeks," they said. What made the latest bout of selling different, Longson and Volynsky said, was that swap dealer hedging -- those willing to make a market for producers -- found themselves needing to go long crude in order to act as a counterparty. In what is referred to as "delta hedging," the market makers were forced to offset their own risk of going long call options by selling futures. The analysts concluded that "successful producer hedges only reinforced selling in the oil market in recent months."