Crude Equilibrium

The last post “Sell! Sell! Sell!”  on November 17^th highlighted the risk faced by shareholders of oil and gas companies.  Large institutions are divesting of shares in fossil fuel companies with increasing frequency, splashing cold water on valuation sentiment.  The world’s largest sovereign wealth fund, Norways’ pension fund, is the latest to make the call.  Norway’s fund managers want protection from a permanent decline in oil prices.  The only thing between shareholders and the downdraft of $37 billion worth of fossil fuel stock hitting the market is an approval vote by Norway’s parliament. 

What are price expectations for oil?  A brief survey of current predictions holds reason for both alarm and comfort for holders of oil and gas company stock.

The chief executive officer of Petrobras (PBR:  NYSE), Pedro Parente, recently made headlines with a prediction of oil prices in a range of $55 to $65 per barrel in the medium term.  Perente was interviewed on CNBC as December West Texas Intermediate (WTI) crude traded at $55.09.

Earlier in the year the commodity team at Barclays Capital had predicted oil to go to $60 per barrel by May or June 2017.  In July 2017, when that failed to materialize, Barclays dropped its forecast for WTI crude to $55 in the near-term and issued a new range of $48 to $60 over the next three years. The British bank also called for $75 per barrel prices by 2025.  The latter prediction is based on the development of a supply gap as economic growth builds demand faster than new oil production capacity is added.

Morgan Stanley on the other hand has recently increased its near-term WTI oil price target from $48 per barrel to $56.  Its 2018 price target $58 for WTI and $63 for Brent crude.  The investment bank’s rationale was based on a proposal by OPEC (Organization of Petroleum Exporting Countries) to keep 1.8 million barrels off the market well into 2018, and the lack of growth in U.S. supply.  Furthermore, U.S. natural gas production appears to have hit a snag in the near-term with plans for expansion as developers are finding it more and more difficult to book hydraulic fracturing equipment and teams. 

Goldman Sachs has targets of $58 and $55 for Brent and WTI crude oil prices, respectively.  The investment bank also cites the OPEC deal as pivotal in setting the equilibrium oil prices.  The group had cut oil production plans last year and now proposes to extend the reduction into 2018. The move is expected to exacerbate a building supply-demand gap.  According to Goldman analysts, natural gas producers are the players to watch for long-term oil prices.  If prices trend higher in the near-term there will be a response among shale oil and other producers to increase production.  This could in turn skew prices to the downside in the long-term.

The price of oil has collapsed since a peak near $120 per barrel in mid-2014.  A world full of struggling economies and weak demand hit the price of oil at the same time the U.S. natural gas market was scaling up.  Apparently, no one thinks the oil price will return to such lofty highs.  If that is the case, then it is the low-cost producer that will survive and the higher cost producers who will likely struggle in the long term.

Capital efficiency is one way to sort out low-cost producers  -  the cost to add an incremental proved reserve to production.  Global Hunter Securities recently named natural gas producer Cabot Oil & Gas (COG:  NYSE) as a winner of this contest with cost of $5.80 per barrel of oil equivalent production.  With its mix of crude oil and natural gas assets Evolution Petroleum (EPM:  NYSE) and crude oil producer Denbury Resources (DNR:  NYSE) follow in second and third places at with $5.84 costs per oil equivalent costs. 

These are exceptionally low in comparison to estimates by consulting firm Rystad Energy and the Wall Street Journal that show the average cost for U.S. shale gas producers is $23.35 per barrel and the average cost for U.S. oil producers is $20.66.  For perspective, it costs Saudi Arabia just under $9 to produce a barrel of oil.  Iran and Iraq both require about $10 to get a barrel of oil to market.  A no-tax environment gives the Middle East countries an edge over the rest of the world.

With costs of producing a barrel of oil ranging so far and wide, it is clear that the future could hold both winners and losers as the selling price of crude fluctuates with supply and demand.  Investor interest in fossil fuels is fluctuating as well.  The direction seems to be away from fossil fuels and that does not bode well for the oil and gas sector, especially the high cost producers.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.