Latest / Energy Economics with Fexingo: Oil Prices, Renewables, and the Cost of Power / How Oil Futures Contango Is Reshaping Producer Hedging
Transcript
- Lucas: So yesterday Brent crude closed above one hundred dollars a barrel for the first time since early June. Luna: And WTI jumped to ninety-one thirty-five, up nearly ten percent in just five days. That is a violent move. Lucas: It is. But here's the weird part — the futures curve is now in contango for the first time in months. That means contracts for delivery six months out are priced higher than the spot month. Luna: So the market is essentially saying 'we'll pay you more to store oil for later'? That seems backwards given the price surge. Lucas: Exactly. And it flips the script for producers. When the curve was in backwardation — futures below spot — the smart hedge was to sell forward aggressively. You locked in high prices now. But in contango, selling forward means you're locking in a discount relative to where the market might go. Luna: Right, because you'd be giving up the potential for even higher prices if the spot rally continues. So producers have to rethink their hedging programs. Lucas: And that's exactly what's happening. ExxonMobil and Chevron both have large hedging books tied to multi-year production. When the curve flips, treasury teams scramble to adjust the mix of swaps, collars, and options. Luna: I remember a few years ago when contango was persistent — back in 2015-16, during the glut — and storage tanks filled up. Are we seeing that again? Lucas: Not yet. Cushing storage levels have actually been drawing down. The contango today is more about near-term demand fears — the market is worried that the tariff situation or a demand slowdown could hit spot prices, while it's pricing in a recovery later. So the forward curve stays elevated. Luna: So it's a bet on a 'V-shaped' demand recovery, plus maybe some backwardation in the outer months? Let me check — the December 2027 contract is at ninety-six fifty, so it's a fairly gentle contango. Lucas: Gentle but significant. For a producer like ConocoPhillips, which hedged heavily in backwardation earlier this year, they're now rolling those hedges into a contango environment. That can reduce the effective price they lock in by a few dollars per barrel. Luna: And those few dollars matter when your capex budget is based on eighty-dollar oil. If your hedged price drops to seventy-eight, you might shelve a Permian well. Lucas: Precisely. The other angle is the storage play. Traders can buy spot barrels, store them, and sell the forward contract — capturing the contango spread. But with Cushing utilization around fifty percent, there's capacity, but the spreads aren't wide enough to cover costs for most. Luna: So the contango is more of a signal than a profit opportunity. Which brings us back to the hedging question — how are producers actually changing their tactics? Lucas: A few things. First, they're shortening the duration of their hedges. Instead of locking in for three years, they're doing twelve-month strips. Secondly, they're using collars rather than straight swaps — so they cap upside but protect downside, because they don't want to miss a potential rally. Luna: That's smart. If you think the curve is wrong — that spot prices could stay high — you want some exposure to that upside. But you still need to protect against a tariff shock crashing demand. Lucas: Exactly. And we saw this play out in the XLE this week — it's up nearly three percent, but it hasn't kept pace with the oil price move. That suggests the market is already pricing in lower corporate earnings from weaker hedging outcomes. Luna: So the stock market is saying 'yes, oil is up, but producers aren't capturing all of it'? Lucas: Correct. The hedging discount is real. And if contango persists, it's a headwind for free cash flow. For a company like Devon Energy, which has a variable dividend tied to cash flow, that could mean a smaller payout next quarter. Luna: You know, this kind of analysis — understanding the mechanics behind the price — is exactly why people listen to this show. If today was actually useful to you, the way these stay ad-free is listener support. Lucas: Yeah, it's at buy me a coffee dot com slash fexingo. That genuine support lets us keep diving into curve structures and hedging without being beholden to anyone. Luna: Absolutely. It helps us keep doing this. So back to the curve — what happens if the contango steepens? Could it attract speculative storage? Lucas: If the spread between spot and six-month futures widens beyond about three dollars, it starts to cover storage costs at Cushing — around forty cents per barrel per month for leasing, plus financing. Right now it's about two dollars, so we're close. Luna: That could quickly absorb the spare storage capacity and put a floor under spot prices. But it would also build inventory, which is bearish later. Lucas: Exactly. It's a classic contango cycle — you store now, create a glut later, which eventually flattens the curve. But that's months away. For now, producers are navigating a market that is simultaneously bullish on spot and bearish on the longer-term outlook. Luna: Which is a tough place to be if you're a CFO trying to sign off on a drilling budget for 2027. Lucas: Right. And that's why we're seeing some producers shift from fixed-price hedging to basis hedges — locking in the differential between WTI and Brent, or between Midland and Cushing — rather than the absolute price. It gives them more flexibility. Luna: That's a more sophisticated strategy. It assumes you can manage the price risk elsewhere. But for smaller E&Ps, that might be too complex. Lucas: Correct. The smaller guys tend to stick with simple swaps or collars. They're the ones most exposed if contango deepens. And that's why we might see M&A pickup — larger players with better hedging programs can acquire distressed smaller producers at a discount. Luna: So contango isn't just a trading curiosity — it's reshaping industry structure. That's a big takeaway. Lucas: Absolutely. It's one of those hidden forces that moves markets slowly. But if you're an investor, watching the shape of the futures curve is just as important as the headline price. Luna: Well said. And with Brent above one hundred, it's a good reminder that the market is always more complex than a single number. Lucas: Next episode, we'll look at how the tariff situation is affecting crude tanker rates — because that's another layer in the cost of moving oil. For now, thanks for listening.