By Julia Payne and Devika Krishna Kumar
GENEVA/NEW YORK (Reuters) - The booming U.S. oil sector is seeing a surge in hedging by producers against drops in regional crude prices to protect revenues from oil sold out of Midland, Texas, or delivered to terminals in Houston after relying for decades on global benchmarks.
The U.S. oil trading market has developed enough liquidity to support new financial instruments to guard against unexpected shifts in local prices, due to pipeline outages or a sudden drop in exports that can ripple through regional crude markets.
Prior to the end of a four-decade crude export ban, most U.S. crude oil that was not used domestically was sent through Cushing, Oklahoma, the delivery point for U.S. West Texas Intermediate futures (WTI) (CLc1).
Now, buyers and sellers are increasingly looking at other points of delivery for pricing, particularly Houston, now that the country sends more than 3 million barrels of oil overseas daily.
"We've got the regionalization of U.S. crude," said Owain Johnson, managing director for energy research and development at exchange operator CME Group Inc (NASDAQ:CME), which about a year ago launched crude futures contract deliverable at Houston
He noted liquidity - the ease of trading a particular instrument due to more active market participants - is growing in contracts trading Houston-delivered oil and grades out of Louisiana's offshore terminal, among others.
The number of outstanding open contracts for the spread between WTI crude delivered to the growing export hub in Houston and to Cushing-delivered WTI futures rose to nearly 160,000 in July, a record, according to CME data.
The WTI Houston contract is based on assessments from price reporting agency Argus Media
"These grades didn't exist as derivatives in 2016 but these are now very liquid markets for hedging," Johnson said.
Hedges specific to oil sales from a particular locale started to spike in the United States in early 2018, according to CME.
Regional price variances have recently hurt producers due to pipeline bottlenecks that kept oil from getting to markets, increasing the need for different contracts to handle the risk.
Last year, prices in Midland, Texas, slumped to a four-year low at about $17 per barrel below WTI futures as surging production overwhelmed pipeline capacity. Producers who hedged using oil delivered to Cushing were hurt by that collapse in local prices which was not mirrored in WTI futures.
"Hedging WTI price risk often suited the risk profile well until regional bottlenecks began to emerge, which in turn exposed producers to risks that previously were not accounted for," said Michael Tran, managing director of energy strategy at RBC Capital Markets in New York.
Open interest in the spread between Argus WTI Midland to WTI futures in September is currently about 130,000 lots, lower than the all-time highs near 180,000 contracts, but still far more than 2017, when it was less than 40,000 contracts.
Companies are taking advantage of new contracts to add to their hedging capacity. Permian producer Parsley Energy Inc (N:PE) and smaller rival shale producer QEP Resources Inc (N:QEP) began hedging using WTI Houston basis swaps for a part of their 2019 production, filings showed.
The companies did not respond to requests for comment.
An oil basis swap is a derivative contract that fixes the price difference between two sales points for specified crude volumes over a particular time period. Several other shale producers already use basis swaps for the spread between WTI in Midland, Texas and WTI Cushing, regulatory filings show.
With a slate of new pipelines coming online in the United States thanks to the shale boom, more midstream companies are now using niche hedging strategies as well, dealers and analysts said.