By Dan Steffens
Before we get into this topic, let me remind readers that crude oil prices are determined on the global market and natural gas & natural gas liquids (“NGLs”) trade on regional markets. The vast majority of upstream oil & gas companies produce a mixture of these three commodities.
Crude oil is one of the most actively traded commodities in the world. Crude oil prices are actually set by speculators that trade oil on the futures market. The oil price you see quoted in the business news each day is the front-month NYMEX contract for West Texas Intermediate (“WTI”). If you live in Europe, it is the front month contract for Brent. Supply/Demand fundamentals eventually determine the price of oil, but all energy sector investors know that “eventually” can take a long time to arrive.
Today, the “Right Price” for oil is somewhere in the $60 to $70 per barrel range.
On November 30, 2016, the Organization of Petroleum Exporting Countries (“OPEC”) decided to shore up oil prices by announcing an agreement to curb production for the first six months of 2017. The price of WTI oil immediately jumped $8/Bbl and moved into a range of $50 to $55 where it seemed to stabilize. The speculators went long on oil, expecting the cartel’s actions to show up quickly in the U.S. storage reports. They forgot some important facts about the oil market:
- It takes about three months for oil production in the Middle East to show up in the U.S.
• Demand for crude oil always dips in the first quarter
• There was a lot of oil in floating storage waiting for a price increase
Instead of U.S. crude oil inventories declining in the first quarter, they increased. U.S. shale oil production is on the rise, but the primary reasons for the builds were increased imports and refiners taking less crude oil during their annual maintenance period. A lot of the U.S. imports during the first quarter were just oil being stored offshore in tankers moving onshore. According to the U.S. Energy Information Administration (“EIA”), crude oil imports into the U.S. increased by 53,000 barrels per day from the eight weeks before OPEC announced their agreement to the eight weeks after the announcement.
At the end of April, the “longs” got tired of waiting for the cartel’s production cuts to tighten the oil market and they started closing their positions. There is a “herd mentality” among commodity traders, so the stampede took WTI from $53/Bbl down to under $45/Bbl.
So what happens next?
The OPEC agreement to cut production by 1.2 million barrels per day is set to expire on June 30th. There is fear that OPEC will decide to resume their war on the U.S. shale oil producers and flood the market again with crude oil. In my opinion, Saudi Arabia and the other cartel members cannot afford to do that, but the market hates uncertainty and the “Wall of Fear” must be taken out for oil and the stock prices of upstream oil & gas companies to move higher.
Traders are eagerly waiting on news from the May 25th OPEC meeting. That is the day on which the cartel will decide to extend their production sharing agreement beyond June 30th. If the cartel does not extend the agreement, the price of oil will probably drop to around $40/bbl and their economies will suffer. Very few cartel member countries can survive another extended period of low oil prices.
Since Saudi Arabia decided to flood the market with oil in mid-2014, the Saudi Arabian International Reserves Fund has declined by over $200US Billion. That has got to hurt and it definitely has the attention of the royal family.
On Wednesday, May 10 two things happened that caused a reversal in the price of oil:
- EIA reported a decline of more than 5.2 million barrels in U.S. crude oil storage levels and an additional decline of 1.8 million barrels in gasoline and distillates inventories (primarily diesel).
• Reuters reported that the key members of OPEC have already decided to extend their production agreement to December 2017 and that there are discussions underway to extend it through next March or June.
Investors should also keep in mind that there is seasonality in the oil market. Each year, demand for crude oil increases by more than a million barrels per day between the first quarter and the third quarter.
In my opinion, OPEC will extend their production agreement into 2018 (March or June) and the announcement will push WTI over $50/Bbl. Weekly draws from U.S. storage (crude oil and refined products) will continue through the summer, pushing WTI over $55/Bbl. If Russia also sticks to their current production targets (a reduction of more than 300,000 barrels per day), there is a chance we see WTI move into the $60 to $70 range by year-end.
The U.S. shale oil producers don’t need $60 oil to make money. Well, level economics are strong in the Tier One areas of the Permian Basin, Eagle Ford, DJ Basin and Central Oklahoma SCOOP/STACK play at $50 oil.
Natural gas and NGL prices are much higher than they were a year ago. In fact, natural gas is up more than 50 percent and most natural gas liquids have doubled in price since dipping under $10/bbl in the first quarter of 2016. Unlike oil prices, which are determined on a global market, natural gas and NGLs trade on regional markets. The U.S. natural gas market is much tighter than it was a year ago and demand will exceed supply by the 4th quarter. Growth in the U.S. petrochemical industry is driving up demand for NGLs.
As investors in upstream oil & gas companies, it is extremely important to know the production mix of the companies you own. Upstream companies provide a breakdown in their quarterly reports.
Conclusion: The outlook for the U.S. upstream oil & gas companies is much better today than it is was a year ago. I follow dozens of upstream companies and their first quarter results were very good, with many of them beating my forecasts and raising their production guidance. Investors in upstream, midstream and oilfield services firms should do well in the months ahead.