The last few months have been a good time for energy commodity investors. Energy prices have been quietly drifting higher for the past six weeks or so, bringing gains since the beginning of December to around 10%.
As prices were rising, it seemed like nobody noticed at first … but they are now reaching critical psychological levels. Brent benchmark crude is almost near its 4.5 month high of $117 per barrel, while U.S. standard West Texas Intermediate (WTI) is close to the $100 level.
What’s so special about $100 per barrel WTI crude? What exactly does it mean for E&P firms and investors? Let’s take a look.
Why It’s Been Moving Higher
Crude oil prices have been getting a boost lately from myriad of factors. First, the global economic picture continues to get brighter. In the U.S., an improving jobs market has helped. Non-farm payrolls rose by 157,000 in January, while the Institute for Supply Management said its index of national factory activity reached its highest level since April. Home prices continue to strengthen, while a “resolution” to the fiscal cliff debacle provided the stock market some firepower.
On top of that, there’s improvement in pipeline infrastructure to consider. Enbridge’s (NYSE:ENB) decision to reverse the Seaway pipeline was critical for WTI prices. Higher oil production — due to adoption of fracking and other advanced drilling techniques — caused a glut of the fuel at the Cushing, Oklah., storage depots.
Because of the few transportation options that could move it quickly to the Gulf and on to world markets, WTI prices languished. But with the reversal of the pipeline and continued expansion of rail transportation, WTI benchmark crude has risen as it has once again be able to be used by the global markets.
A soft landing across the sea in China sure isn’t hurting either. Surveys of Chinese manufacturing showed that the Asian Dragon’s factories remained on track to produce a mild recovery. Meanwhile, the debt-plagued and austerity-ridden eurozone’s manufacturing sector had its best month in a year despite recent contractions.
At the same time, Iran and the Middle East are still a tinder box. Iran has continued with its nuclear ambitions, despite sanctions and restrictions preventing it sell its crude oil output. Negotiations between Iran and the five permanent members of the U.S. Security Council have made little progress. U.S. ally Israel is worried that Iran is moving closer to developing a nuclear weapon.
Israel has thus recently made some moves to prevent any future attacks on its statehood. This past weekend, the nation hinted that it may have been behind the airstrike on a missile site in Syria meant to destroy weapons it believes were headed for Lebanon. Lebanon is the base of the militant anti-Israel group Hezbollah. Iran reportedly told Israel that it would regret the strike against Syria. The bottom line? Tensions are still rising.
Combined, all these factors have helped push both measures of oil upwards over the last few weeks.
Why Does It Matter?
So with WTI and Brent moving higher, why is the $100 a barrel so critical for investors? Aside from the psychological round number (which makes for good headlines), the amount does have some impacts on the E&P industry and consumers.
The most important, perhaps, is production costs. As global demand continues to rise, E&P firms have had to look toward unconventional sources in order to keep supplies coming. These assets are often located in remote areas of the world and require complex drilling techniques to access the hydrocarbons. All of this costs major amounts of money, and ultimately the costs get passed down to the consumer. Exxon’s (NYSE:XOM) famed CEO Rex Tillerson remarked last year that “The cost per barrel clearly is going up, with the size, the magnitude and the conditions with which we’re making some of these investments.”
With oil prices at $100 per barrel, a variety of projects in deepwater, shale and bitumen production have become profitable. Oil companies are often reluctant to give precise cost information, but between the rising costs of specialized equipment, raw materials and labor required to access these more expensive operating environments, analysts peg average costs north of $90 per barrel for WTI crude. Some have even estimated that the newest shale and ultra deepwater plays may require $114 per barrel oil to even be possible. Record profits aside, the E&P needs these higher crude oil prices to survive and justify drilling.
Rising WTI prices can only mean one thing to consumers: higher gas and heating oil prices. Over the last few months, prices for gasoline have been relatively low as lax demand and lower WTI crude prices have caused a surplus. However, with WTI now rising fast, higher feedstock costs will undoubtedly be passed on to consumers. Nobody likes paying more to fuel up their car. Sadly, though, with the global economy regaining some of its strength and many E&P firms plowing into unconventional assets, it may be a long-term reality.
The big picture in all of this is that over the longer term — even with rising supplies due to shale and deepwater sources — we are going to have higher sustained energy costs. The $100 a barrel mark can be thought of as relative floating price floor with regards to production margins.
The lesson for investors is to have a dose of energy-related stocks in any portfolio. Pairing a broad energy-focused fund like the Vanguard Energy ETF (NYSE:VDE) with a more specialized energy play like my favorite SPDR S&P Oil & Gas Equipment & Services (NYSE:XES) could makes a great way to gain from on rising demand and energy prices. At a bare minimum, it’ll help hedge what you put in your tank.
As of this writing, Aaron Levitt was long XES.