Hedging Strategy Likely Exacerbated Oil’s Fall - The Wall Street Journal

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Sarah Toy

Sarah Toy
The Wall Street Journal
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Feb. 12, 2020 8:00 am ET

Fears over the impact of coronavirus on global growth quickly dragged oil into a bear market.

Photo: Photo Illustration by Emil Lendof/The Wall Street Journal; Photos: iStock

A scramble by Wall Street to reduce exposure to falling oil prices may have hastened crude’s recent descent.

In just 19 days during January, crude prices tumbled 20% from their recent peak. That was the fastest slide into a so-called bear market since early 2016, according to Dow Jones Market Data.

Analysts blame the slide on fears the coronavirus will hit the global economy and weaken demand for oil. The speed of the decline also suggests it was fueled by big banks making bets designed to hedge deals with oil companies, some traders said.

Here’s how that happens: Oil companies expect to produce a certain amount of crude at future dates and want to protect themselves from swings in the price of oil. They do so by buying financial instruments from banks and other financial firms that typically give the oil companies the right to sell a specific amount of crude at a prearranged price, known as the strike, within a given time frame.

If the price of oil heads toward that strike price, the financial institutions on the other side of the trade need to protect themselves against losses. These firms do this using another set of financial instruments, but those trades can put further downward pressure on the price of oil.

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For instance, banks may have felt compelled to sell crude futures in January as prices moved downward toward the strike price, said Robert Yawger, director of the futures division at Mizuho Securities USA. For U.S. crude, $50 tends to be a popular strike price, he said.

Such trades help institutional traders and banks mitigate the risk associated with oil-price swings. But traders say they can also amplify price movements, especially when firms start making them en masse.

“You end up with this situation where the price is going down because people are worried about falling demand due to the coronavirus. Then on top of that, you have these financial institutions that have written these hedges coming and selling more futures,” said energy economist Philip Verleger.

Although such trades likely exacerbated crude’s most recent fall, traders and analysts say the recent plunge was driven by key supply-and-demand issues. Crude futures have fallen 0.8% so far this week, with West Texas Intermediate futures settling Tuesday at $49.94 and Brent, the global gauge of prices, settling at $54.01.

The shale boom, spurred by horizontal drilling and hydraulic fracturing techniques, has transformed the energy industry and flooded the market with oil and natural gas in recent years, pushing down prices for those commodities. In January, the U.S. hit record levels of output, producing 13 million barrels a day some weeks.

Although producers have promised restraint, investors are still skeptical that oil prices will rise. During the week ended Feb. 4, hedge funds and other speculative investors cut net bets on higher U.S. crude prices to their lowest level since November.

Slumping oil prices have hurt shares of energy companies in recent years. The S&P 500’s energy sector has been the worst-performing group in the broad index over the past two years and recently notched its worst January on record.

Energy giants Chevron Corp. and Exxon Mobil Corp. are among the weakest-performing stocks in the Dow Jones Industrial Average, with both falling around 11% in January. Shares of EOG Resources, Inc. lost 13% last month and oil-field services company Schlumberger Ltd., which in January said it planned to pull back from the U.S. amid a slowdown in shale drilling, saw its shares fall 17%.

And the coronavirus, which has sickened more than 40,000 people and caused more than 1,000 deaths in China and spread to other countries, is now hitting oil demand. The Chinese government has closed off the hardest-hit cities and several countries have advised citizens against nonessential travel to China. Multinational companies are suspending business trips to the country, and the World Health Organization has declared the coronavirus outbreak an international public-health emergency.

“Globally, oil demand won’t grow meaningfully if not for China,” said Michael Tran, energy strategist at RBC Capital Markets. “China is the world leader when it comes to oil-demand growth.”

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—Gunjan Banerji and Amrith Ramkumar contributed to this article.

Write to Sarah Toy at sarah.toy@wsj.com

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