The recent oil price run up has led many to believe we are headed to the marginal cost of production.
(SOURCE: EOG)
Most would like prices to move into the range EOG Resources highlights above. $65 to $75/bbl oil provides very good economics in US core unconventional locations and would add to an already impressive gain in the US Oil ETF (NYSEARCA:USO).
(Source: Yahoo Finance)
The key to this move is its commonality with 2015. It happened a couple of weeks earlier, but the same move last year saw the 50-day (red) intersect with the 100-day green) in mid-May. This bullish move was followed with a relatively flat USO. At the end of June, the USO saw the start of a significant drop. In late July the 50-day crossed below the 100-day. The 50-day began a bullish move again in 2016, but no one knows if this is the start of a prolonged bull market for oil, or if we see another drop.
Big improvements have been seen in world oil markets, as supply has continued to decrease while US demand has improved. Supply disruptions in Iraq, Kuwait, Nigeria, and Libya have all helped to balance supply and demand. This has been aided by natural declines from several countries including Brazil, the US and Venezuela. The key is if this is transient in nature or the beginning of something bigger. Oil prices could have difficulty in breaking above $50/bbl due to the possibility of production coming back on line. The US Fed is also an issue with a probable hike in June. Three hikes are possible in 2016, but the current nature of the Fed may lead to just one. More emphasis seems placed on the stock market than economic numbers, which could be a mistake. A stronger dollar is probably ahead, but the timing is the question. The possibility of increased production from low cost producers may also occur. The no-deal at Doha may push OPEC members to seek increased revenues. The Saudis recently stated production could increase by 2 million bbls/d in the next 6 to 9 months. It may be forced to increase production depending on Iran’s ability to enter the market. Bloomberg recently stated Iran had increased production by 600K bbls/d since sanctions were lifted. Some believe the number is closer to 400K bbls/d, but it has been successful in getting back on line. With over 50 million barrels stored on the Gulf, Iran has large volumes to push in Europe and Asia. It is possible the oil markets have already balanced, but the upcoming refinery maintenance will substantially decrease throughput. This could lead to another pull back, but the hope is for a better year in 2017. No matter how one looks at the situation, it is difficult to grasp the direction of this market.
Half of world crude production comes from areas like the Middle East, but the oil sands, Russian arctic and conventional US are more important. These have higher production costs and are the new swing producers. OPEC and Russia may be able to increase production, but a large number of analysts do not believe this is the case. Although only a small percentage of world supply, US unconventionals could do more to effect oil prices. This isn’t necessarily based on its ability to increase production in a low price environment, but maintaining production with hedges. Operators are currently being pressured by banks to add to its hedge book. Hedges can meaningfully affect how much a bank will decrease the operator’s credit. When operators hedge production, it manages to put a ceiling on crude prices.
There are a large number of differing opinions on when and what price operators will start hedging production. Given the volatility of oil prices, most operators want to lock in at a price with a decent rate of return. Some believe operators wont hedge until we see forward pricing of $60/bbl, while others think a much lower price is needed. This article focuses on operator hedges developing areas with the lowest costs. We believe there could be significant resistance oil prices heading higher in 2016. When looking at operator hedges, it is best broken into a range delineated by the core areas of the three top producing oil plays. The first is the Permian. This includes the best areas of both the Midland and Delaware basins. These core areas produce decent returns at $45/bbl to $55/bbl WTI. In the Eagle Ford, core areas need between $50/bbl and $60/bbl. The Bakken, due to higher taxes and wider differentials, needs $55/bbl to $65/bbl. Since most analysts see oil prices improving in the 3 rd and 4 th quarters, it is possible operators will wait to hedge. It is also likely the lowest cost producers will be proactive just in case the market drops in a meaningful way.
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