[Editor's note: A version of this story appears in the August 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]
Zigzagging a path through recent trade friction and geopolitics has often been bewildering. Is market sentiment for the day “risk-on” or “risk-off”? A Wall Street Journal article likened the “risk-on, risk-off” phenomenon to market forces being split into two buckets. One has “haven assets” that rally when investors “grow skittish.” The other has “growth assets” that rally as “risk appetite returns.”
To state the obvious, commodities like oil are not risk-off or haven assets. And “skittish” is likely an understatement of energy investors’ mood. A recent Simmons Energy note detected some “increased investor scrutiny in assessing risk/reward” in energy. However, it noted, “the complexity factor has never been higher as multiple externalities continue to drive a wide range of outcomes.”
According to the Simmons note, generalist investors have set a high bar to consider returning to energy.
E&Ps’ ability to generate a free cash flow (FCF) yield is a “threshold requirement,” and a FCF yield in line with that of the S&P is targeted. “Given the weak competitive structure of the upstream industry and the prolonged legacy of underperformance,” the Simmons note said, “generalists increasingly require minimum FCF yields of about 5% and a persuasive line of sight to low double digits.”
A surprisingly narrow divergence in the oil price can, according to Simmons, makes a significant impact on FCF. At a $50-per-barrel (bbl) West Texas Intermediate (WTI) price, about 20% of Simmons research coverage can deliver 5% or more oil growth and generate a 5% FCF yield. But with only a small shift higher to $55/bbl, as much as 65% of its coverage can grow at 5% or more and generate a 5% FCF yield.
The smaller group meeting the 5% FCF metric at $50/bbl, said Simmons, is tilted toward “large-cap diversifieds and high-quality Permian pure-plays often with scale.”
A report by Bernstein also sees $50/bbl as a pivotal level. If using cost of capital as a target rate of return, it said, even in the Permian a majority of producers fail to hit their cost of capital at $50/bbl. However, at $60/bbl, “roughly half” of producers manage to hit the target, skewed to those with larger footprints and blocky acreage. Bernstein said $60/bbl is “near marginal cost” for crude in North America as a whole.
With $5 to $10/bbl fluctuations in price able to move U.S. oil economics meaningfully on the margin, making forecasts is difficult, especially if oil demand suddenly drops markedly. In this year’s first quarter, according to Energy Information Agency data, global demand for crude was growing at a meager pace of around 300,000 barrels per day (bbl/d), the “weakest since 2011,” noted Simmons.
The problem: “U.S. supply growth outpacing global demand growth isn’t a comforting outcome,” observed Simmons.
A Macquarie note, however, cited certain factors indicating that “demand is bad, but looks worse than it is.
“We estimate global product demand was reduced by 800,000 bbl/d to 1 MMbbl/d from February to April 2019,” said Macquarie. Distillate demand, in particular, was hit by “abnormally mild winter weather” in Europe, Asia and the Middle East. Also, it noted, Midcontinent flooding “reduced crude runs, gasoline demand and diesel demand by disrupting U.S. planting seasons.”
With refinery turnarounds taking longer than normal, “we are six weeks behind a normal ramp-up in refining runs,” said the Macquarie note in mid-June. With normalized weather and the end of the turnaround season, third-quarter global refinery runs are projected to be up 2.5 million bbl/d over prior quarter levels. In turn, it said, this should “at the least create a strong floor for price.”
With an ongoing emphasis on capital discipline—and a drive to generate FCF—will the U.S. E&P sector moderate its production growth? As of June 23, the 48-month WTI strip stood at roughly $53.50, according to Simmons, partway to the $55/bbl level that would allow almost two-thirds of its research universe to achieve 5% growth coupled with a 5% FCF.
A risk is that production growth continues to be too much of a good thing. One issue is that, even if the public and private E&P sectors dial down growth, only time will tell if the majors “revisit their unbridled growth agenda,” said Simmons. Notably, Exxon Mobil Corp. and Chevron Corp. unveiled ambitious growth programs in the Permian earlier this year.
Of course, geopolitics remains a huge variable. Could Mideast skirmishes escalate into real conflicts in the region and provide a much more bullish backdrop for oil? Or does rising U.S. supply, as one observer suggested, provide a kind of “firewall” against geopolitical events?
Risk-on, or risk-off?
Recommended Reading
Verdun Oil: Quietly Leading the Eagle Ford’s Refrac Rally
2024-08-23 - Verdun is among the largest private producers left in South Texas, with more than 285,000 net leasehold acres and 90,000 net boe/d across the Eagle Ford Shale trend and the Giddings Field.
Go Long: Exxon, EOG Extend Permian Laterals, Lead US Onshore Drilling
2024-09-05 - When it comes to drilling in U.S. onshore basins, no other operators are drilling more than Exxon Mobil and EOG Resources, according to Enverus data.
CEO: Berry Seeks Horizontal Drilling Opportunities in Uinta Basin
2024-08-13 - Berry Corp., which has a large footprint in California’s San Joaquin Basin, might be more excited about deals and drilling near its Uinta Basin acreage.
Midcon Momentum: SCOOP/STACK Plays, New Zones Draw Interest
2024-09-03 - The past decade has been difficult for the Midcontinent, where E&Ps went bankrupt and pulled back drilling activity. But bountiful oil, gas and NGL resources remain untapped across the Anadarko, the SCOOP/STACK plays and emerging zones around the region.
Hess Goes Forth in Bakken with Chevron Deal Entangled in Dispute
2024-10-30 - Waiting to close a $55 billion sale to Chevron, Hess Corp. plans to continue running four rigs in the North Dakota Bakken shale play through the fourth quarter.
Comments
Add new comment
This conversation is moderated according to Hart Energy community rules. Please read the rules before joining the discussion. If you’re experiencing any technical problems, please contact our customer care team.