How can you remove uncertainty from the oil market? The quick answer: You can’t.
Whether it’s price volatility, geopolitical factors, liquidity constraints or weather volatility, you can’t remove uncertainty from the market. Not completely.
But, you can put parameters around uncertainty that can help you think more rationally about it as you make hedging decisions for your business.
You see, uncertainty is an unbounded concept, you can’t control it. The process of risk management helps to add some borders and construct to something you normally wouldn’t be able to control.
In fact, one of the questions I get all the time at industry meetings and conferences is: “Where’s the price of crude going to be in six months?” Folks, if I knew the answer to that question, I’d be sitting on an island somewhere sipping a margarita!
We need to get away from discreet price concepts and think about market states and how various price scenarios can impact your profitability.
Put more simply: we can’t control the markets. But, we can develop frameworks for analyzing markets and implement risk plans that allow you to express your views within organizational risk tolerances.
To develop these frameworks, we need to think in terms of market structures – or “themes” that frame the market. Here are four primary themes driving energy markets to consider as you build out your framework for managing uncertainty in 2018:
Theme #1: Rebalancing
This is one of the most important themes driving the energy space the last year or so. Rebalancing represents the interplay between OPEC+ (Russia) and U.S. shale production. The main question being, can OPEC+ cut production deep enough to make a meaningful impact on global inventory levels and drive prices higher? Competing against these global production cuts, are U.S. producers who are looking to take advantage of the resulting high price environment. In addition to U.S. shale production, at high enough levels, we will also start to see conventional crudes come into play.
The key here: closely following production statistics. In the energy industry, this means following crude oil production and the dynamic between OPEC cutting production and U.S. Shale increasing production. Watching what OPEC is doing with production, and now U.S. Shale responds, should be a key input in how you rebalance on a quarterly or annual basis.
Theme #2: Commodity Financialization
With this theme, it’s all about money flows. As commodity markets continue to become more financialized, a growing pool of investment capital continues to impact pricing in this space.
These flows break down primarily between active and passive investors. Active money tends to move in and out quickly on shorter term fundamentals. They can also cause significant price volatility if large positions are being initiated or liquidated.
Passive money tends to be ‘stickier’ and will stay in the market as long as total returns are sufficient. Returns are viewed as spot price returns as well as roll yields. Roll yields are driven by the term structure of the forward curve and, as such, backwardated markets tend to attract more passive investment for longer.
For example, in 2017, total commodity assets under management (AUM) was approximately $311 billion—that was up $45 billion from 2016. Rising oil prices and robust global growth largely drove that rally. And, we’re seeing the same thing occur already in 2018. As commodity markets become more “financial”, we’ll need to pay even more attention to money flows.
As hedgers, we need to pay attention, in particular, to extreme investor positioning, because if the fundamentals don’t deliver, then there could be significant impact on pricing and market volatility.
Theme #3: Geopolitical risk
In 2017, we saw numerous geopolitical risks. The most important for energy markets are the ongoing issues in petrostates such as the uprising in Iran and government failures in Venezuela, just to name a couple. And, given the current climate, we’re bound to see more in 2018. In fact, we’re dealing with multiple geopolitical issues in 2018 that simply didn’t exist the last few years. Now, it’s virtually impossible to assess whether these risk factors will actually occur. But, you need to be keeping your eye on this constantly.
Theme #4: Macro-economic risks
Can global growth continue in a robust and coordinate fashion? How will emerging markets perform in the year ahead? How will the U.S. dollar do in 2018? Will volatility in the markets return? How will the return of inflation (real or expected) impact what has been a low volatility, low cross asset correlated market?
These are all macro-economic risks that will impact your approach in the year ahead.
How these “themes” play out in 2018 will impact how we, as hedgers, participate in the markets. As you strategize, I recommend you read: The Modern Risk Management Approach: An 8-Step Checklist.
Remember, you can’t eliminate uncertainty from the markets. But you can make confident decisions utilizing diversified strategies and a proactive approach to risk management by developing frameworks for analyzing and thinking about markets a bit differently.