What the Oil Price Roller Coaster Means for the Industry

The last two trading sessions have produced some historic rises in crude oil prices. This morning’s decline, however, indicates that the roller coaster ride is hardly over.

Much of that decline can be written off as profit taking. Hardly surprising: In only two trading sessions, the West Texas Intermediate (WTI) benchmark crude rate saw a better than 17% rise, while London’s Dated Brent benchmark rose 15.7%.

Some pundits are further suggesting this morning that concerns over whether the Fed will raise rates in September are also contributing. Now, a quarter of a point rise (and then some) has already been worked into the bond market. But any Fed rate rise will have an impact on high-yield energy debt, as we shall see in a moment.

However, it is the spike in the price at the end of last week that had everybody talking. This does not mean we are on our way to $80 a barrel oil anytime soon. But it does mean that a floor may be forming.

Here’s what this trend will mean for struggling U.S. oil producers… and for OPEC…

How Short Covering Contributed to the Price Rebound

The spread between short contracts on crude (betting prices would go down) and long contracts (betting prices would rise) had been the most pronounced in six years. A veritable overhang of shorts had weighed upon the market. Once prices began recovering, those shorts needed to be covered to avoid catastrophic losses. The short covering merely accentuated the price rise.

Oil prices for some time have reflected three overriding concerns: excess supply, demand levels, and fiscal sustainability. Excess supply continues the debate over the sustainability of shale oil production is in the U.S. Producers have found ways to cut costs and keep afloat, but the reality remains that $45 oil will force many companies out of business.

Not all of them, mind you. But the unconventional production requiring horizontal drilling and fracking, deep wells, and very expensive upfront capital expenditures will be pressured at any pricing point below $62-$65 a barrel.

OPEC Is Struggling

The key here may well be someplace else – closer to where the slide intensified last Thanksgiving. Then, a Saudi-led (some would say a Saudi-browbeaten) OPEC opted to defend market share rather than price. That guaranteed a decline that has rippled through the market ever since.

All OPEC producers are now in negative territory when it comes to revenues versus central budget needs. Riyadh has even returned to floating global bonds for the first time in years.

But before you decide we ought to have a bake sale and help them out, remember this. Saudi Arabia, Kuwait, the United Arab Emirates, and perhaps even Qatar (where the revenue flow is natural gas, not oil) can withstand the current pricing a bit longer, even as they move into budget deficit territory.

It is the rest of the cartel – countries like Venezuela, Nigeria, Libya, Algeria, Ecuador, Iran, and Iraq – that have been forced into producing well beyond their monthly quotas, thereby accentuating the pricing decline as they attempt to acquire revenues “by any means necessary,” figuratively shooting themselves in the foot along the way.

As I noted here in Oil & Energy Investor previously, there is even evidence that Saudi and Kuwaiti sovereign wealth funds have been shorting their own production to keep prices low, because defending market share continues to be their main interest. Needless to say, this is not going over well with more vulnerable OPEC members.

Global Oil Demand Increasing

American production, while showing some strain, has remained remarkably resilient. Given the improvements in cost cutting and the introduction of new technology, inexpensive, shallow, vertical, formula drilling in well-known (and seismically studied) basins will benefit from locking up additional market share at home. As long as demand remains.

Which brings us to the second consideration. The persistent rant about demand decline is not only overdone. It is simply wrong. Prices are determined globally, not in the U.S. or Western Europe. Both OPEC and the International Energy Agency (IEA) are projecting that global demand rates will come in at record daily levels this year.

And that leaves us with a final consideration. The Achilles heel of U.S. domestic production remains on the debt side. Here, company operational fiscal sustainability requires that debt be rolled over. That, in turn, demands additional production at a decent market price.

The Major Storm About to Hit U.S. Oil Producers

As I have observed in Oil & Energy Investor on several occasions, most American producers are cash poor. They rely on debt to cover forward operating expenses. And here, a major storm is under way.

Energy debt is in the highest-risk category of debt graded below investment quality. These are called “high yield” by some, “junk bonds” by others. They carry two significant premiums in what a company has to pay to float them – a higher interest rate above investment grade bonds and a further cost against other junk bonds.

Without a substantial rise in the market price for oil, this debt encumbrance will become unsustainable, a situation that’s likely to begin as early as next month. The result will be a wave of liquidations, bankruptcies, and mergers/acquisitions kicking in during the last quarter of the year.

This shake-out will make things quite interesting, because the combination of a stabilizing and then slowly rising oil price with a tide of mergers and acquisitions will provide us some very nice investment moves.

Editor’s Note: Just as I am finishing this Oil & Energy Investor essay, word is coming that OPEC has signaled they are prepared to talk with other producers about the pricing issue.

Looks like somebody just blinked.

The post What the Oil Price Roller Coaster Means for the Industry appeared first on .

Powered by WPeMatico