Price drop brings a slap-in-the-face reality to oil.
Gravity finally caught up with the oil market.
A dead-cat bounce in oil prices since January has finally fallen flat as speculators abandoned the futures market, recognizing that the surplus of oil is here to stay for months, maybe a year to come.
The price drop, though, could inject some reality into the larger oil and gas industry that will see assets revalued in the second half of the year as lenders determine how much debt these companies should possess. The result could be a badly needed consolidation of oil exploration and production companies.
The futures prices for West Texas Intermediate oil settled at $52.33 a barrel on Tuesday, down 15 percent since June 23. That ended several months of stability around the $60 mark.
This step-down in price is part of a correction that began in June 2014, when West Texas Intermediate peaked at $107. Since then global demand has weakened, OPEC has said it will not prop up prices, and oil companies have cut budgets.
Oil prices bottomed out at $43.46 in March, and by May drillers already had idled 1,000 out of 1,900 North American rigs.
“That price is a nonsustainable price, so it’s perfectly reasonable to make a bet at those levels when the rig counts were moving lower,” said Brian Barnhurst, a principal and credit analyst at Prudential Fixed Income, which has $543 billion in assets under management. He recently completed a white paper on investing in the oil and gas industry.
What was surprising after the price dropped was how much money was ready to bet on oil and the companies that produce it. Because of low interest rates and inflated stock prices, few other assets offered the same potential return as oil, so the money poured in. Speculators bought a record number of contracts expecting oil prices to rise, while oil companies issued $10 billion in stock and $34 billion in bonds.
Some investors tried to outsmart the market by getting ahead of it, so they looked past record inventory stored in tanks or in uncompleted wells. They disregarded U.S. Energy Information Administration statistics showing that even with the drop in drilling, the lower 48 states were still setting records for production. They ignored the rising number of rigs in Saudi Arabia, and OPEC countries exceeding the daily quota by 1.3 million barrels a day.
False sense of value
Perhaps most surprisingly, investors failed to appreciate that while the supply of oil kept growing, demand remained relatively flat. This ran up the price for gasoline for consumers, of course, but it also gave oil companies a false sense of how much their companies were worth and explains why they resisted mergers.
“The price run-up changed producer behavior,” Barnhurst said. “It limited the incentive to act more rationally given the low oil price environment.”
But once the big oil speculators booked their second-quarter profits on June 30, they started selling and the bottom fell out. Analysts offer many explanations ranging from the Greek debt crisis to the Iranian nuclear talks to China’s weak financial markets. Whatever the excuse, though, the reality of supply and demand suddenly took over the oil markets on July 1.
“Global demand for oil looks to be weakening, just as U.S. shale production was starting to ramp back up,” said Jim Krane, fellow for energy studies at Rice University’s Baker Institute for Public Policy. “Add to that the likely re-emergence of Iran as a major exporter — and the lack of coordination within OPEC for Iran’s return to oil markets — and you have the makings of a glut.”
Quick recovery seen
That’s not what many Houston-based oil companies were counting on. Many saw the quick price recovery to $60 a barrel as a sign that the yearend price would be $80 a barrel, a level that would make producers profitable again. Instead, the Energy Information Administration on Tuesday forecast that prices will average $55 in 2015 and $62 in 2016.
The second half of 2015 will be unkind to many oil company balance sheets.
One way that companies balance risk is to sell futures contracts, or hedges, that can guarantee oil companies will earn a set price a year in advance. But with the anniversary of the crash coming, the old hedges are rolling off, and some oil companies will be exposed to current oil prices for the first time.
Lenders and bond analysts also will re-evaluate the value of the oil companies’ assets later this year. Some may see their asset value, bond ratings and ability to borrow radically reduced. A lot of management teams will have a moment of reckoning when they see how their debt compares with cash flow and asset value.
“Companies with good assets and stretched balance sheets may become motivated sellers in the back half of the year and early 2016,” Barnhurst said. “There’s no shortage of capable buyers ... particularly well capitalized super-majors and large independents, as well as those with mediocre assets but good balance sheets.”
The oil exploration and production sector is ripe for consolidation, and the rush toward mergers and acquisitions that should have begun six months ago may finally begin.
More to come
Barnhurst said it will take at least six months before supply and demand become more reasonably balanced. Based on his research, oil companies need $65-$70 a barrel to pay for new wells once the market balances.
It’s important to remember, though, that the upheaval is far from over. The oil and gas sector will remain one of the most fascinating spectator sports in town.