Oil's Magic Numbers
Round numbers enjoy an enduring and somewhat mystifying popularity in markets. A few years ago, the oil market had a very round and pleasing one in the form of $100. These days, it makes do with $50.
Even this diminished level has a talismanic potency. On Monday, Wood Mackenzie, an energy consultancy, announced that oil companies rushed to add hedges on their production in the last three months of 2016 at a faster pace than the previous four quarters, based on its analysis of 33 large producers.
The trigger: oil's jump above $50 a barrel after OPEC and several other countries announced supply cuts at the end of November. You can see what they mean in this chart showing how producers' short positions in Nymex crude oil futures -- a proxy for how much future production E&P companies are selling -- have been changing over time:
Still, 50 isn't some magic number. Leaving aside that we all know the real magic number is actually three, the true significance of $50 oil only becomes apparent when you consider numbers on either side of it; namely $40 and $60.
Despite the big strides in productivity made by shale drillers, $50 isn't a comfortable price level for them. Take five large domestic producers: Concho Resources Inc., Continental Resources Inc., Energen Corp., EOG Resources Inc. and Pioneer Natural Resources Co. Collectively, they produced 1.24 million barrels of oil equivalent per day in 2016, with 55 percent being crude oil.
Their realized price for that crude -- which differs from the headline Nymex number -- was a little less than $40 a barrel before any hedging impact, data from their 10-K filings show. Once you factor in the natural gas and liquids making up the other 45 percent of their output, their overall realized price per barrel of oil equivalent was just $27 and change -- lower even than in 2009 just after the financial crisis.
Bump the realized price for crude oil up to $50, and, all else equal, their realized price overall rises to a little less than $33 -- better, but still only about half of what they got in 2014 before the crash took hold. Indeed, you would have to put the crude price up to about $65 before their overall realized price for 2016 nudges back above $40 (again, all else equal).
However, we can all agree that $50 is waaaaay better than $40. And hedging is about managing risk rather than taking a firm view on some price level being the 'right' one. So when E&P companies took their chance to add hedges after the OPEC meeting, what they were doing was making sure they lived to fight another day.
This is especially important in an industry whose spending habits make it reliant on selling new shares and tapping the bond market to make its cash flow math add up.
Investors and bankers are more persuadable when the oil price begins with a "5" or more, rather than less. It's worth pointing out that while the average yield on energy junk bonds had stayed flat around the 7.5 percent mark in the two months leading up to OPEC's meeting in late November, it dropped by more than a percentage point in the two weeks following.
In the past week, oil futures for 2018 have dripped back below $50 a barrel, making it less appealing to hedge next year's production. This, in turn, could cause the ramp-up in shale drilling activity seen in recent months peter out, meaning the recovery in U.S. oil production softens later in 2017.
This is a critical number to watch. Andy McConn, an analyst at Wood Mackenzie, reckons the real magic number for 2018 is more like $55 or $65 a barrel. At that level, he says, many larger E&P companies could fund growth of 5 or 10 percent from their own cash flow.
All of which helps explain why the big event of the weekend, the meeting of the committee monitoring the supply cuts announced by OPEC and its partner countries, was a bit of a non-event. Oil sold off on Monday due to the lack of a clear signal that the cuts would be extended past June.
But OPEC's de facto leader, Saudi Arabia, couldn't really let that meeting have any clearer outcome. OPEC's production surged in the run-up to November's agreement, after Saudi Arabia in September signaled its willingness to support prices. Promising a continuation of cuts now, rather than waiting until May's formal meeting, would simply be a signal for Saudi Arabia's partners to slack off on compliance -- as well as, of course, give shale producers more of a chance to hedge. Better to keep everyone at least a little uncertain about what happens next.
As I wrote here, I doubt Saudi Arabia's ability to manage expectations this finely. Partly, that's because of the need to prime the market for the upcoming IPO of Saudi Arabian Oil Co., or Saudi Aramco, which appeared to move a step closer with news that the country is slashing the company's tax rate. But it is also because the magic range between despair and euphoria for oil producers of roughly $40 to $60 has become so tight.
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