It Is a Risky Business Being a Shale Producer, but You Did Have an Option

12/25/2014 7:00 am EST

Focus: STRATEGIES

Greg Michalowski

Chief Currency Analyst, FXDD

Greg Michalowski, of ForexLive.com, shares a story about the risk involved with being a shale oil producer, but how they can protect themselves and how this correlates to the risk that traders must deal with and how they focus on it rather than remain in fear of it.

We all hear/read about the negative from the oil collapse. Shale producers are not hedged. The gold rush in the shale states is over. There will be massive defaults.

I don’t doubt that there will be losers out there, and you can be sure we will hear about the biggest losers.  It is no different than when we hear about the biggest winners.  Last week we heard about a high school senior at a prestigious NY city school who made $72 million trading stocks at lunch time (ended up being a series of lies which spiraled out of control).  Finding the biggest winners and the biggest losers is part of the system. It is part of the game. So yes, there will be losers and yes we will hear about them.

With regard to oil, what I always wonder is if you are a producer, and you can quantify your cost fairly well, and you know your selling price, you can determine—roughly—what you can make or not make.  So you should have an idea where your breakeven price is including profit.

If you know those things, you should understand your risk and then you can hedge that risk, not when it is falling like a stone but before. That is why there are options and other derivatives that should be used to protect or hedge real business.  An oil producers business is not to speculate on the price of oil, but to have costs on one side (which are relatively constant), selling price on the other, which is more variable and making a profit is the result. The more variable risk should be the concern if you are a producer.

So, if you are a producer and did not hedge, it won’t be the first time. It won’t be the last time, but it is a big mistake for your oil producing business.

How much does it represent in total? I don’t know. I am not sure anyone knows, but there may be stories that claim they know.  Are they accurate? I don’t know.  One thing I can probably say is “Are the losses worse than the housing crisis when every house price was slashed?”  I doubt it. So we got that going for us.

Where does oil eventually go? Commodities tend to be a self correcting thing. If there is too much demand, the price goes higher, production increases as producers love to sell more at higher prices and the price eventually goes lower. If there is not enough demand, production will be cut, consumption will go up, and a bottom is found. Is $54 the low? Like the question on how much is the total loss, the answer is “I don’t know,” but that level will be found. It may be $34. It may be $74.  No one said the price does not lie from time to time.

NEXT PAGE: See How It All Comes Out in the Wash

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I am reminded of 2008 when oil was heading above $140. I was at a family gathering in Chicago and there was an oil trader there. We got to talking and he had oil going to $200. China this, china that and it was the story at the time (remember commodities were being bought up for the 2008 China Olympics) My simple response was if oil goes to $200, the global economy will collapse. If it is to collapse, oil will come down then. Well oil came down and the economy collapsed.  Oil went down to $32 by the end of the year.

Anyway, my point is there may be shale producers who go belly up and we will see their stories on the nightly news. On the other side of the ledger is the good from lower prices, which is a benefit to all who use energy (which is everyone). It may be $50 a month for each car owned or family, but those $50 bills add up.

What will stop the slide in price? If more gas guzzlers are bought, there will be more oil demanded. If people go on more trips, there will be more oil demanded. If producers go idle, there will be less supply.  If producers keep on producing because they can get it out at $30 all-in and sell at $54, there will be more supply.  If OPEC is overproducing to put the high cost producers of of business, well that is a different story, but hopefully, there were many who hedged their business, and when the price goes back up after the rinse and spin cycle are over, they can come back in and bring more competition to the OPEC cartel.

Meanwhile, more efficient ways of extracting, transporting, etc. oil can be explored so that the there is a more balanced playing field (i.e. more options for energy) PS. alternative sources of cleaner energy should be further explored as well. I would love to see a world less reliant on oil, more reliant on cleaner energy and at a lower price. It will be the new technology revolution that solves imbalances in balance of payments, and price inefficiencies due to monopoly-like power.

We will see how it all comes out in the wash.

In the meantime for traders, our business is about risk too.  And the variable price of things like the stock market, oil, currencies, etc. may lie from time to time, but if we apply tools to that price that tells us, both bull and bear, we too can control our risk, just like the oil producers should have done…Oil producing is a risky business. Trading is a risky business too. Most everything is risky. If you have risky businesses, you should focus on risk. If you can beat that, the reward should take care of itself.

By Greg Michalowski of ForexLive.com

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