Coronavirus and the oil price war
We know the global economy is slowing down as a result of Covid-19. This is a negative for oil prices. We also know that Saudi Arabia is opening the pipelines to flood the market. As far as we know, this is to “punish” Russia for not maintaining the cartel by production cuts at this moment of declining prices.
Oil is, at pixel time, down to some $25 a barrel. This is not going to be sustainable for many producers. This is what we know so far.
(WTI price from OilPrice.com)
A prediction – or supposition perhaps
JBC Energy takes us a stage further. We expect this to be a short – OK, perhaps medium term – sweating of the market by the lowest cost large scale producer, Saudi Arabia. Thus, futures prices are going to be higher than spot. Obviously, this is not true of all cargoes everywhere, but as a general prediction, it’s useful enough.
We also know what happens when there’s such a contango. It becomes profitable to store oil bought at the current spot price to sell at some future date. The costs of storage plus financing costs are lower than the price difference. And of course a liquid futures market means this can all be hedged as well. We’ve seen this at least once in large volume, actually, we saw it the last time there was such a collapse in the oil price.
We’re fine so far, we’re within the experience of the recent past. But what happens when all the available storage space is being used? Last time around it paid to rent – some are rumoured even to have bought tankers on their way to breaker’s yards – tankers and park them for a year or more. But what happens when all the oil storage tanks are full, all tankers are in use?
With a conventional oil reservoir, it’s not possible to simply turn off the taps and then come back later to extract. It’s possible to reduce pumping, sure. And stop using enhanced recovery techniques for a bit. But actually, ceasing operations means losing at best some part of the total extraction possibility from that reservoir. It’s entirely possible to end up with a well that cannot be reused.
This is not an absolute, it’s a tendency though. So, once a conventional well has been drilled and piped up, there’s a certain insistence on continuing to use it until it is exhausted. This is why oil supply is inelastic in the short term. “Turning off the tap” isn’t something that really works.
Where this prediction is going a bit wild is in saying that for some production we might in fact see delivery prices – that is, before transport – go negative. By negative I do not mean here that they fall. I mean producers, at the wellhead, paying people to take the oil away. This won’t translate through to gas station prices, but really could happen at select locations to the guys pumping it up out of the ground.
At which point we will see some of that capacity closing and that will, from the above facts about how it all works, permanently remove such production from the global market. This actually being what it is surmised the Saudis want to do. Kill off some of the competing production. Thus, prices rise, they make out like bandits and are happy.
However, here is where we see the difference between fracked wells and conventional. A conventional field costs billions to get going and needs to be kept going. With fracking it’s mere millions to get a new well up and running. Further, the bolus of production comes in the first 18 months or so, with a long tail of much lower production rates. These are entirely different models of capital investment, of revenue streams and this of the base financial structure.
For, what happens if oil goes negative – and we can drop that assumption, just say it goes low enough for long enough that some of the conventional production closes, who suffers? Clearly, all conventional producers do. Frackers also of course, and given the highly geared nature of most companies, they probably depart the scene.
But as I’ve said before, an oil price crash doesn’t wipe out the technology, those Permian Basin rocks aren’t going anywhere. And the Texas oil patch (just as an example) is possibly the most entrepreneurial place on Earth. So, fracking production would start up again as soon as the oil price is sufficient for the drilling of new wells to make sense.
But, given the end of the price war, a recovery in the global economy, that new equilibrium price is going to be higher than it was before this little battle playing out before us right now.
In the medium term, this price war is actually bullish for the WTI price and thus any royalties associated with it. It’s horrendous for any of the current fracking companies of course.
The specifics of oil geology and conventional wells mean that production that leaves the market as a result of the current low prices is – probably – permanently removed from the market. Sure, the low price will play merry havoc with current producers but it is bullish in the medium term for WTI and royalty flows associated with it.
The investor view
There is a thriving market, in Texas especially, for royalty shares from particular pieces of land. For those adventurous and expert enough this might be worth looking at. This is not a general recommendation for the general investor as ensuring that what is being bought is what is purported is not simple. For experts only this market.
For us more general investors, the imperfect proxy is to look to the oil majors. As I’ve mentioned before, the Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) dividend yield is looking very attractive indeed. BP is also trading at near absurd levels. It being worth noting that both are less reliant upon the oil price itself than many assume. As it falls, so do the royalties they have to pay and so too do refinery profits rise.
The real thing to take from this is that the fallout from the current oil price war will be more complex than most are assuming. Fracking will resurge as a result of any conventional production being permanently locked out of the market. Simply because it is a lower investment and shorter time to market form of oil production. The people who will really suffer will be those countries – yes, countries and national oil champions – who depend upon the absolute value of oil from their conventional reservoirs.
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.