In this article we ask and answer: “Should a private investor look closely at oil and gas exploration and development opportunities now? What do the pundits think?”

One of the most fundamental aspects of equity investing is understanding the companies & sectors in which one is investing. There are numerous sectors in the investment universe that require specialized knowledge to make educated investment decisions. Oil & gas is, undoubtedly, one of them, with myriad acronyms and terminology, overwhelming to investors new to the space. 

Sidestepping the standard due diligence required for any educated investment, e.g., the management and history of the company, structure of the investment, etc., this article identifies four oil and gas industry factors, trends & forecasts to help investors in their learning & decision processes:  

• Market Fundamentals: O & G Supply & Demand Expectations
• Exogenous Factors: Geopolitical Supply Shifts
• Technological Advances: Lower Drilling Break-Evens
• Institutional Industry Outlooks: Exploration & Production(“E&P”) 

We’ll address each below. 

Summary 

• Market Fundamentals: We can expect prices to remain steady in the near-term. A tightened supply-demand balance, OPEC’s dwindling spare capacity and recent increases in capital expenditures (CapEx) described below contribute to speculation that energy commodity prices will remain steady or increase in the near-term 

• Exogeneous Factors: Almost all geopolitical events have positive impacts on oil & gas prices. Since much of the world’s oil is produced and exported by OPEC, geopolitical strife either between OPEC member nations (Shi’a, Sunni), or between OPEC & the US (terrorism, etc.) leads to risk premiums being added to energy commodity prices and, therefore, rising prices. 

• Technological Advances: Forced into survival mode in 2015, American O&G producers have proved innovative & resourceful. Drilling and completion costs have gone down substantially since the O&G market crash of 2015, with advances in horizontal fracturing and enhanced oil recovery techniques increasing production and reducing spacing between units.
• Institutional Industry Outlooks: Many (and most) reputable institutions that have published oil & gas industry outlooks expect prices to stay steady or increase in the near-term future. Notably, the Moody’s industry outlook is presented below, and the Deloitte Industry Outlook is referenced as source material throughout this article. 

Favorable Oil Supply & Demand Expectations 

Introduction  

During periods when production (or the ability to produce) exceeds consumption, crude oil and petroleum products are either stored, or production capacity is catalogued as reserves. Both situations result in a decrease in prices, as actual supply exceeds demand, or as forecasted reserves indicate spare capacity respectively. 

In 2014, as the oil & gas industry experienced record high prices, the U.S. capital market responded by investing heavily across the oil & gas industry vertical. Capacity to produce went up, and OPEC’s ‘spare capacity’ (more on this later) remained steady at ~5B bbls (barrels) of oil. As shale plays and horizontal fracture stimulation were changing the landscape of the American O&G industry, OPEC responded to the threat of increased U.S production by flooding the market with its, heretofore, ‘spare capacity.’ In conjunction with increasing American production, OPEC’s action caused an unexpected, near catastrophic drop in oil prices from $140/bbl to as low as $28/bbl in 2015.  

Many American O&G producers declared bankruptcy with obvious immediate, negative effects on production, capacity to produce and, eventually, supply. Capital expenditures dropped, leading to longer-term supply shortages. In the years since, the markets have adjusted to the shock of 2015 and have recently witnessed a tightening balance between supply and demand, suggesting the potential for an increase in crude oil and natural gas prices in the near term. 

If nothing else, we can expect (and futures evidence this) prices to remain steady in the near-term future. Note, we have already seen a $12.10 increase in West Texas Intermediate (“WTI”) prices from December 2017 to May 2018.¹  

OPEC, Spare Capacity & Forecasted Supply²

OPEC member countries produce approximately 40% of the world’s crude oil and its exports account for nearly 60% of petroleum traded internationally. Because of this market share, OPEC’s actions can, and do, influence international oil prices. Indications of changes in crude oil production from Saudi Arabia, OPEC’s largest producer, frequently affect oil prices. 

The extent to which OPEC member countries utilize their available production capacity is often used to indicate the tightness of global oil markets, as well as to reflect the extent to which OPEC is exerting upward influence on prices. EIA (the U.S. Energy Information Administration) defines spare capacity as the volume of production that can be brought on within 30 days and sustained for at least 90 days.  

Saudi Arabia, the world’s largest oil exporter, historically has had the greatest spare capacity. It has usually kept more than 1.5 – 2 million barrels per day of “spare capacity” on hand for market management. 

OPEC spare capacity provides an indicator of the world oil market’s ability to respond to potential crises that reduce oil supplies. As a result, oil prices tend to incorporate a rising risk premium when OPEC spare capacity reaches low levels. From 2003 through 2008, OPEC’s total spare capacity remained near or below 2 million barrels per day (or less than 3 percent of global supply), which provided very little cushion for fluctuations in supply in a context of rapidly rising demand. 

Capital Expenditures Trends & Consequences

Although worldwide capital spending is still 19% lower than the record numbers seen in 2014, the U.S is the largest driver of the capex recovery (see below), indicating investor confidence in the efficiency and efficacy of shale techniques and American production.  

The fall in WTI to $26/bbl in February ‘16 precipitated steep falls in headcount & CapEx and significant restructurings and bankruptcies as bank loan redeterminations caused havoc in the industry. Investment into infrastructure, midstream assets and oilfield services companies precipitously dropped to near-zero levels, the consequences of which we continue to see today, with a tightening supply-demand gap as noted below (net draw in each quarter ’17, ’18). 

Exogenous Factors Often Positively Affect Oil & Gas Prices

Contrary to most investments, almost all unpredictable world events (wars, civil unrest, unstable regimes, disruptions of supply due to extreme weather conditions) increase oil and gas prices as a direct result of the higher risk associated with supply capacity and ongoing production.³ 

Markets are influenced by geopolitical events within and between OPEC countries because they have, historically, resulted in reductions in oil production. Given OPEC’s market significance, events that entail an actual or future potential loss of oil supplies can produce strong reactions in oil prices.  

Reduction in Drilling Cost Break-Even

Since the rapid expansion of horizontal drilling less than 10 years ago, the industry has achieved significant advances in technology and completion methods. Wells are now being drilled more accurately⁴, at faster rates, and with longer laterals — sometimes multiple laterals.⁵ Wells that wouldn’t have been economic, or even successfully drilled, are now being completed with more complicated fractures, including tighter clusters and shorter intervals, using higher densities of proppants⁶. Overall, this has shifted breakeven costs downward for drillers by decreasing overall costs, while increasing IP (Initial Production) rates and EURs (Estimated Ultimate Recovery). Wells are drilled more cheaply, on a dollar per foot basis, and resources are extracted more easily, on a unit per foot basis.⁷

The question coming into 2017 was whether these reductions were sustainable. The evidence suggests they are, with break-even costs across the major US shale plays still 30-50 percent below the levels of early 2015. In looking at cost reductions, it’s also worth considering how US natural gas producers have lowered and sustained costs, especially in the Marcellus and Haynesville gas plays. If this is indicative of the path for oil, costs may stay down (and need to) for a long time.⁸ 

E&P Industry Earnings Forecast

Moody’s expected outlook is stable for the integrated oil and gas business over the next 12-18 months. Earnings will rise about 5% even as conditions remain strained as companies seek greater returns on upstream⁹ investments. A return to positive free cash flow could compel major European companies to reinstate cash dividends.  

Moody’s outlook for the E&P business remains positive, with earnings likely to rise more than 10% in 2018 amid increasing production volumes, helped by modestly higher capital spending.OGJ Editors, Oil & Gas Journal,¹⁰   

What should this mean for investors?

The downturn of 2014 saw many E&P companies fold or restructure and capital markets were understandably reluctant to invest in new projects in 2015 and early 2016. American O&G producers responded (as we always do) by embracing technology and making extraordinary efficiency gains on a per barrel of oil basis. 

Geologists and engineers began, through implementation of 2-D & 3-D seismic data and FMI logs to understand with exactitude the subsurface geology precipitating an increase in completion rates and a decrease in occurrence of dry-hole completions. All of this is to say, the American producer learned how to produce at a substantially lower break-even than previously. 

With supply continuing to lag behind demand in the markets, due to the scant capital expenditures in 2015/2016, OPEC’s low level of reserves, a lower break-even for American producers, and a stable price outlook, the industry is prime for investment.  

For more information about different industry sectors, please peruse our Knowledge Base.  We continue to expand our investor resources to enable you to be as informed as possible before investing in private offerings. 

1. https://www.statista.com/statistics/279941/west-texas-intermediate-wti-crude-oil-price/
2. EIA, OPEC Supply, https://www.eia.gov/finance/markets/crudeoil/supply-opec.php”
3. John England, “Deloitte Oil & Gas Industry Outlook 2017”, https://www2.deloitte.com/content/dam/Deloitte/us/Documents/energy-resources/us-er-2017-oil-and-gas-industry-outlook.pdf
4. Accuracy in drilling: factors include automated pipe-handing, improved drilling rates (new bit designs, use of underbalanced drilling and geosteering.
5. Lateral: the length that a well extends laterally, rather than vertically into the earth. Lateral distances often range from 4,000 feet to 10,000. Multiple laterals decrease costs and saves time in drilling and completing the well.
6. Proppants: a solid material, typically sand, treated sand or man-made ceramic materials, designed to keep an induced hydraulic fracture open during or following a fracturing treatment. It is added to a fracking fluid which may vary in composition depending on the type of fracturing used and can be gel, foam or slickwater-based.
7. https://www.freedoniagroup.com/industry-study/oklahoma-oil-and-gas-drilling-outlook-drilling-activity-by-wells-and-rigs-in-stack-scoop-other-areas-3526.htm 
8. https://www2.deloitte.com/content/dam/Deloitte/us/Documents/energy-resources/us-oil-and-gas-outlook-2018.pdf
9. Upstream, midstream and downstream terms refer to the position on the supply chain. Upstream refers to identifying deposits, drilling and recovering materials. Transportation and pipelines of the materials, as well as storage, fall into the midstream definition. Downstream includes refining and marketing.
10. https://www.ogj.com/articles/2017/12/moody-s-oil-gas-industry-to-continue-recovery-in-2018.html