Sale Of The Sea­son

How to dodge risk in a low-price en­vi­ron­ment with­out sac­ri­fic­ing op­por­tu­ni­ties when the up­swing re­turns

Alberta Oil - - SMART MONEY -


at al­lo­cat­ing more cap­i­tal to the Cana­dian en­ergy sec­tor right now, there are many oth­ers who are think­ing this might be the chance of a life­time to buy oil and gas eq­ui­ties at his­toric lows. It’s a con­trar­ian stance, for sure. But how much more bad news can be out there? Some might sense a move to­ward ca­pit­u­la­tion when even the most bullish an­a­lysts have thrown in the towel. But ca­pit­u­la­tion can of­ten mark the turn­ing point in these volatile mar­kets. It’s a matter of stom­ach­ing the what-ifs.

What if global oil de­mand fails to live up to ex­pec­ta­tions and the Ira­ni­ans are able to bring an­other 500,000 bar­rels per day to the mar­ket? Oil sup­ply out­side of OPEC should be fall­ing, but what about ­Pi­o­neer Nat­u­ral Re­sources’ re­cent $1.5-­bil­lion eq­uity is­sue? It’s largely go­ing to fund an ex­pan­sive U.S. capex pro­gram with the ex­pec­ta­tion that Pi­o­neer’s pro­duc­tion growth will ex­ceed 15 per cent per year for the next three years. If that kind of big cap­i­tal is still out there be­ing de­ployed, how are we sup­posed to get a re­bound in price? Gold­man Sachs talks about the risk of a global oil stor­age prob­lem this year, which could cause a fur­ther sell-off ­po­ten­tially down to $20 per bar­rel. And on the nat­u­ral gas side, if the winter stays warm and we don’t ex­pe­ri­ence a hot sum­mer to drive air con­di­tion­ing loads and in­crease de­mand, stor­age con­ges­tion and very low prices will be­come a real risk in this mar­ket as well.

The ac­com­pa­ny­ing chart shows the con­sen­sus view in the oil mar­ket around the prospec­tive average price for WTI in U.S. dol­lars in 2016. Most in­vestors are aware of where the spot WTI fu­tures con­tract is trad­ing, and some are aware of where the for­ward strip price is ­trad­ing for 2016 – and beyond. But not many are aware of the ex­pected dis­tri­bu­tion around the price. This is not a sub­jec­tive view of the dis­tri­bu­tion – it is based on ­ob­jec­tively ­ob­served mar­ket prices in the oil fu­tures and op­tions mar­kets in the first week of Jan­uary. The chart il­lus­trates the ­prob­a­bil­ity that the average WTI price will fall below the price lev­els in­di­cated on the x-axis. For ex­am­ple, based on early Jan­uary pric­ing, the mar­ket is say­ing that it be­lieves there is a 36 per cent prob­a­bil­ity that the WTI price this year will average below $35.

As an in­vestor, one doesn’t want to miss the im­pact of a sud­den cycli­cal up­turn in the mar­ket, but one can’t ig­nore the risks that most pro­duc­ers will face in an ex­tended low-price en­vi­ron­ment. The key is sus­tain­abil­ity over the next 12 to 18 months, mean­ing de­ter­min­ing which pro­duc­ers are in the best po­si­tion to weather a low-price en­vi­ron­ment. ­In­vestors will wisely ex­am­ine bal­ance sheets and ­man­age­ment team strength. But don’t for­get one other very im­por­tant fac­tor: the ­mag­ni­tude of ex­ist­ing hedge po­si­tions. Com­pa­nies with a sig­nif­i­cant com­po­nent of their pro­duc­tion hedged for the bal­ance of 2016 and into 2017 will have an edge on their peers with re­spect to sus­tain­ing cash flow in a dif­fi­cult price land­scape. And ­of­ten these hedged pro­duc­ers will have bet­ter ac­cess to cap­i­tal mar­kets. Case in point: The afore­men­tioned Pi­o­neer Nat­u­ral Re­sources had 85 per cent of its oil and 70 per cent of its gas pro­duc­tion hedged for 2016 at the time of its re­cent eq­uity is­sue. One ma­jor geopo­lit­i­cally based sup­ply dis­rup­tion is all it takes to turn the cor­ner on this thing in a hurry, but the op­por­tunis­tic in­vestors will also want to en­sure that their pro­ducer eq­uity in­vest­ment will sur­vive any fur­ther com­mod­ity price weak­ness.

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