The WTI crude oil futures market on 11/7/2017 broke through the $57 per barrel mark on news of the unrest in Saudi Arabia that broke over the weekend. (See story here) In doing so the front month contract is now in territory it has not traded in very often since it broke below $60 per barrel in August of 2015. The big question is whether the current market move will be confirmed as a bullish move in oil, or yet another false rally dowsed by continued over-supply by U.S. shale oil production.
Front Month Oil Futures Breaks Higher in a Range Bound Market
The futures curve is the best place to start when trying to get a handle on what is actually happening in the oil market. And currently the market shows a clear spike in the near-term, but traders are very reluctant to place any bets that the rally will hold in the future. This doesn't mean that the rally won't hold, just that the market is not betting that it will.
The orange line in the graph shows the price of futures contracts for delivery of a barrel of oil out through the end of 2022 on November 6th 2017. These prices reflect an aggressive run-up over the prior week. But the more interesting aspect of the price pattern, and I have written about this over the past several years, is that the current front month contract is running up to the level that equates to what a futures contract for a barrel of oil cost in the August time frame of 2015. Meanwhile the back end of the curve remains anchored at $50, and from time to time drops back toward the levels established when the market bottomed in February of 2016, but it rarely breaks below the level.
Why is this pattern important? The futures market is currently stuck in the range established at these two calamitous trading time frames. Until an event or market change occurs which breaks down these barriers, either higher or lower, the oil market will likely remain in this trading range. The market is currently testing the upper bound of the range for conviction to see if the market will support a move above the August 2015 breakdown point. The lack of conviction on the back end of the curve is a pretty good signal that no traders trust that the shale patch can control their production well enough for higher prices to hold.
Déjà vu - A Similar Pattern Emerged Post Trump's Election One Year Ago
A year ago, right after the Trump election the oil futures market prices exhibited the same pattern that is emerging today. As you can see in the chart below, the futures curve broke higher on the front end of the curve in December of 2016. The mini price spike occurred as OPEC countries and then non-OPEC countries (Russia included) announced that they would all adhere to a level of production constraint going forward to help bring the market back in balance.
The price move upward was even supported by a move upward in the longer dated contracts through mid-January of 2017. However, the test whether the market would support higher prices failed miserably. After mid-January the oil market fell lower as the U.S. shale producers swept into the market to lock in delivery contracts at the $54-$56 mark, and then pushed their production higher quickly by completing wells that were previously drilled but not fracked.
Shale Oil Production Peaking, But Still Historically High
The graph below shows the acceleration of U.S. production that happened subsequent to the favorable move higher in futures prices at year end 2016.
The pivotal question now is whether the shale producers have a lot of low hanging fruit left in their inventory of drilled but "unfracked" wells. The production chart is now showing a near term peak which is below the level reached in 2015. This pattern coincides with the fact that the industry is now far more capital constrained than it was at the height of the "hype" about the promise of fracking back in 2012 to 2015. But as the chart also points out, production levels above 9M barrels per day are considerably higher than 9 years ago, and are at levels not reached since the early 1970s. If the production levels cannot be sustained at the current levels, and there is clear evidence that availability of capital and other issues make the current production rates a future challenge, then the market may tighten much quicker than investors currently expect.
World Oil Supply and Demand Now More Balanced
A review of global inventory data by the IEA shows that in 2017 demand has been outpacing supply. The more balanced market is a result of worldwide constraints on capital spending on new oil exploration and production that began back in 2016, and coincided with the announced OPEC and Non-OPEC cuts at the end of 2016.
According to the IEA, "Our global crude and product balances show inventories drawing in 2017 by 0.1 mb/d and 0.2 mb/d, respectively. For next year, the crude and product markets look broadly balanced, assuming OPEC holds output steady at around current levels." (See full report here)
Shale Production - Financial Discipline Still Questionable
Given the balanced supply and demand outlook for oil globally, the real test facing the industry is whether over investment in horizontal drilling is finally under control. For a perspective on this question, take a look at a sample of financial data compiled on 6 prominent shale plays: (PXD) (CLR) (WLL) (CXO) (RRC) (OAS)
As a group, with the exception of Continental Resources, none of these companies were able to make money in 3Q 2017. In fact, several are in worse shape now from a profitability standpoint than in 2015 even though oil prices were 7.1% higher during 3Q 2017. And yet, 4 out of the 6 have considerably higher stock prices.
August of 2015 was a time period in which the oil patch was undergoing a dramatic shift in market expectations, and the stocks of many of the companies were in decline. But underlying all the turmoil was a futures market which was setting the expectations for future company earnings. In August 2015 the oil market had a five year forward price level that averaged $57.16 per barrel.
Fast forward 2 years later to August 2017, and you find a market that averaged $48 per barrel in 3Q results, but expectations for future prices over the next 5 years now average $52.01 per barrel, much lower than in August 2015. The market reaction to this shift is very interesting. Several companies in the sample, like WLL and RRC, have seen their stock prices cut significantly in value. On the other hand, Pioneer Resources PXD and Concho Resources CXO have recovered and continue to have high flying stock prices. Continental Resources CLR is also trading significantly higher.
The consistent market theme is that if the company is expected to have the financial resources to continue to weather the breakeven price conditions without a serious liquidity concern, the stock price is being bid up to levels well above what a $50, or even $57 per barrel oil market should rationally say these shares are worth. This speculative buying pattern continues despite the inability of any of these companies to generate a profit at the current price of oil, with the exception of the negligible profit at Continental Resources.
The efforts by shale oil and gas producers to survive and maintain the increased production levels since 2012 come at a cost. This cost can be readily tracked on every shale company balance sheet thru time by looking at the net change in the capital the shale producer has to spend relative to the change in reserve levels at the company. If a company is burning through capital at a rate higher than the value of the reserves it is booking for future use, or visa verse it is selling reserves in order to stay liquid at prices that do not return enough capital to pay down debt or increase share value, the company's financial condition deteriorates.
In the case of shale producers, the high decline rates for the first 2 years of production in horizontally drilled wells mean significant capital is continually required to keep the reserve balance intact, and even more capital is needed to increase the balance. Four companies in the sample - (PXD, CXO, and OAS) over the past 21 months have tried to outrun the shale "production cliff" by selling shares or issuing debt (RRC) and continuing to invest in new wells through drilling or acquisitions. The other two companies (CLR, WLL)) have attempted to shrink their way to prosperity in the Bakken by selling reserves and reducing debt, choosing to invest only as much as internally generated funds will allow.
In the 6 company sample of the capital cost to fund reserve changes since 2015, only one of the companies (OAS) has been able to book new reserves at levels which cover its full net change in capital sources over the past 21 months.
As a composite group, the sample producers added $3.62B in reserves at a net capital spend increase of $5.96B in cash draw downs, net new debt issuance or new shares issued. And, as the clock ticks, these new reserves continue to be a liability to shareholders as the companies sell their reserves from inventory at continued unprofitable market price levels. As a group, only (RRC) was able to take on debt during this time frame to build reserves. All the other companies were forced to pay down debt. I think this provides clear evidence that the debt market is shut-off to a majority of the shale E&P companies at the present time.
Only (PXD) in the sample actually maintains a significant cash balance ($2B) which it can use to finance expanded reserve exploration outside of internally generated funds. The remaining companies are very cash poor with most balances at $11M or below.
With this market backdrop, it is little surprise that U.S. oil production is finally starting to show a second peak at a lower level than 2015. As long as capital constraints in the industry continue, I expect a U.S. production decline to materialize as we move thru 2018.
Large Cap Oil Companies Return to Profitability
Next, look at the performance improvements now being experienced by the large integrated oil companies: (XOM) (RDS.A) (BP) (COP) (OXY) (MRO).
The large cap oil companies have responded to the collapse in oil prices since 2015 as expected. They lowered operating costs and curtailed capital expenditures just enough to get the profit line back to break-even. All of these companies are doing better from a bottom line perspective with the exception of Exxon (XOM). These companies as a group, however, are not gearing up to continue to flood the market with production. Across the board the large cap oil companies continue to have negative cash flows when you consider the amount of capital expenditures they are making just to keep their reserves intact and make the hefty dividend payments they have committed to the market.
Large cap oil stock prices have responded by moving higher in all cases relative to August of 2015. Presently the stock market, as opposed to the futures market, is aggressively pricing in expectations that the market price of oil will make a move back toward levels experienced prior to August of 2015. In fact, given the PE multiples on these firms today, all of which are 20+, the market needs a return soon in my opinion to justify recent accelerated market moves.
Break-out above $60 needed to confirm an Oil Bull Market Return
The surge higher in oil futures prices, particularly on the front end of the curve from December '17 through May '18 reflects a tightening world oil market. However, fear remains that the shale producers will spoil any rally with continued over investment to bring more capacity on-line at the $56 level.
Given the increased production experienced from late 2016 through 3 quarters of 2017, you can't argue with a market that is now in a "show me" condition on the long-end of the curve. Therefore, I think the current run in oil prices will be a challenge to sustain, just like it was at the end of 2016. However, if you look at the price moves in many of the stocks in the oil sector, you can see plenty of expectations that the $60 mark will be pierced in the near-term. You can see this signal by reviewing the stock price change and earnings performance of companies in the shale oil patch and the large integrated oil companies relative August of 2015.
My personal expectation is that the futures market is likely to push through $60 per barrel in WTI crude oil market (already well above on the Brent contract) in the near term. However, until the U.S. production numbers decline below 9M and remain lower, the price is unlikely to move significantly higher unless there is a major disruption to supply somewhere in the world market.
Daniel Moore is the author of the book Theory of Financial Relativity: Unlocking Market Mysteries that will Make You a Better Investor. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.