Oil prices fell to historic lows on Wednesday, before surging yesterday. What it means for the oil stocks in your portfolio
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***On Wednesday, U.S. oil prices fell to their lowest levels in 18 years
Below, you can see how this latest price collapse compares to other collapses during this millennium.
West Texas Intermediate (WTI) futures, which are the primary gauge of U.S. crude, fell 24% on Wednesday, down to $20.37 a barrel. That’s the lowest level since February 2002.
Meanwhile, Brent crude, which is the global benchmark, fell 13%, down to $24.88 a barrel, its lowest settlement since May 8, 2003.
Thankfully, oil staged a massive rally yesterday based on a report that Washington is considering intervening in the Saudi/Russian price war which is largely behind the recent sell-off.
Crude futures spiked nearly 25% to $25.36 upon hope that the Trump administration will help stabilize prices by convincing the Saudis and Russians to cut production.
However, as I write Friday morning, oil futures are down 4% to $24.17 a barrel. Unfortunately, this price is existentially-low for many U.S. producers. More on that in a moment.
First, as to why oil prices have collapsed, they’re getting nailed on two fronts: excess supply based on the Saudi/Russian price war just referenced, and reduced demand, based on the coronavirus grinding global commerce to a halt.
If you’re unclear on the Saudi/Russia spat, two weeks ago, members of the Organization of the Petroleum Exporting Countries (OPEC), met in Vienna to discuss what to do about the coronavirus’ impact on lowered global demand for oil.
Russia is not an OPEC member. But Russian officials were invited to the meeting because three years ago, Russia entered into a deal to coordinate its production levels alongside OPEC.
At the meeting, Saudi Arabia, recommended the member-countries cut their oil production by roughly one million barrels per day. The Russians didn’t go along with the plan. Early speculation was because the Russians wanted prices to remain low to kill off the U.S. shale industry.
The Saudis were offended, and proceeded to flood the market with oil. Last week, Saudi Arabian Oil Co. (run by the state) said it will increase its “maximum sustainable” production capacity to 13 million barrels per day.
Since then, the Saudis and Russians have continued talking, yet it appears there’s no coordinated sign of cutting production. So, at least for now, supply remains robust.
Meanwhile, on the demand side, stricter lockdowns from governments around the world to combat the coronavirus are cutting into oil consumption. Flights are grounded, borders are closing, citizens aren’t driving (here in Los Angeles where I live, we’re now officially in lockdown) … it’s all pointing toward lower prices to come.
Given these supply/demand dynamics, expect a glut of oil in the second quarter. It’s basic Econ 101 that far more supply than demand will put further pricing pressure on oil.
In fact, Goldman Sachs just slashed its price target for the second quarter to $20 a barrel.
***All of this points toward pain for high-cost U.S. oil producers
From The Wall Street Journal:
The slide in oil prices is already punishing high-cost producers in the U.S. shale patch and is one factor pushing the world economy toward recession, analysts say.
American oil producers are expected to slash output and investment, while containment measures implemented to slow the coronavirus’s spread may stop consumers from spending much of the money they save from cheaper gasoline at the pump.
Over the last five years, U.S. shale oil producers have been working to reduce their drilling costs. While these efforts were somewhat successful, the reality is that, at $24.17 a barrel, prices simply aren’t high enough for some producers to make any money.
There are hundreds of oil shale producers in the U.S. Most of them budget for oil between $55 and $65 a barrel. With prices now having plummeted to less than half of that, these producers are having to idle rigs and cut employees.
It turns out just 16 U.S. shale companies operate in shale fields where the average cost for oil production is below $35 a barrel. As an example, Exxon is one of them, able to be profitable at $26.90 (in its New Mexico fields).
Occidental, which we profiled in the Digest last week, is another sub-$30 producer. But its shares have been destroyed in recent weeks, down as much as 78% since early January.
Even though Occidental can operate at low costs, doing so would leave very little cash left over (if any at these prices) for debt service.
And that’s a big fear — fracking is such a highly capital-intensive business that many producers finance with debt. Occidental carries a $40 billion debt load. Historically-low oil prices threaten its ability to pay its debt service, hence investors feeling.
***If you own shale-producing companies, the timing of its debt maturity is important
High debt isn’t necessarily an atom bomb. It’s the timing of the maturity of that debt that’s important.
Fortunately, earlier this week, CNBC reported that of $86 billion in debt that exploration and production companies have to refinance or repay by 2024, only $5.3 billion is due this year. The biggest chunk is due in 2022, at $25.7 billion. This gives the production companies a little breathing room.
Plus, only 10 companies in the production sector account for nearly half of the debt coming due by 2024. The biggest? You already know the answer — Occidental. But none of it is due this year.
Given this, an immediate default isn’t the concern. But the name of the game has now become “cash conservation.”
Unfortunately, investors can expect to feel this. For example, Occidental said it was cutting its stock dividend by 86% to conserve cash. (For context, Occidental spent more than $2.5 billion on dividends last year. That was more than double the amount it spent on interest payments on its debt.)
***So, what’s an oil investor to do with this?
Even though we saw a monster rally in WTI’s price yesterday, this is not an automatic “close your eyes and ride it out” moment if you’re an oil-production investor.
As one oil analyst put it on Wednesday, “what we are seeing here is essentially the atomic bomb equivalent in the oil markets.”
If you own oil production companies, it’s critical that you research your company’s break-even production cost. Find out how it’s addressing this crunch — is it shutting down rigs? Postponing expansion into new shale fields? Cutting a dividend? Has it effectively hedged the price of oil at higher levels? If so, for how long?
Beyond this, dig into your company’s financial statements to find out when its debt matures. The longer you have, the better. And what’s the cash position on the company’s balance sheet?
Armed with this information, you may decide to ride out the storm, or you may choose to sell. That will be a reflection of what your research turns up, as well as your unique investment situation.
Either way, as you research, remember — the name of the game is cash preservation. The companies with it will survive. Those without it may be forced to shut their doors.
Bottom line — if oil prices remain in the low $20s for a sustained period, many players in the U.S. shale industry are facing an existential crisis. As the CEO of Pioneer Natural Resources recently said, “probably 50% of the public E&Ps (exploration and production companies) will go bankrupt over the next two years.”
Let’s cross fingers that yesterday’s rally is the beginning of a price-comeback that proves him wrong.
We’ll continue to keep you updated.
Have a good evening,