In this bonus episode, Justin and I provide an update on the recent collapse in crude oil prices, how the Coronavirus is impacting global oil demand, the future of US oil and gas companies, and what this all means for the market for mineral rights and royalties. We also talk about the silver lining to the drop in oil prices.
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Timeline of Events:
- The effects of Coronavirus outbreak on global oil demand was seen in early 2020. The IEA and EIA revised their demand and oil price forecasts down (see MRP 47: Mineral Rights News for March 2020 for more information). The decreased demand for oil and gas was in part due to the decrease in economic activity as result of Coronavirus (COVID-19) quarantines, travel restrictions, and decrease in manufacturing activity in China.
- OPEC ministers tried to force Russia to join them in production cuts of 1.5 million barrels a day as a response to the coronavirus impacts on demand.
- In the OPEC+ meeting held on March 6th, OPEC and its allies failed to reach an agreement to extend curbs in crude oil production. They told Russia if they didn’t join them in cuts to oil production, then OPEC would abandon proposed cuts altogether. Russia did not agree to these cuts so Saudi Arabia slashed crude prices over the weekend, targeting potential buyers of Russian oil. Both Russia and Saudi Arabia both pledged to increase production in the near future.
- Oil markets responded with turmoil and oil dropped the most in almost 30 years on Monday March 9th – the biggest drop since 1991 Gulf War.
- On Tuesday, March 10th, Saudi Arabia pledged to raise its April crude oil production to record levels to put additional pressure on Russia (and US shale producers).
- Russia responded with their energy ministry calling a meeting with Russian oil companies on Wednesday, March 11th to discuss future cooperation with OPEC. Russia left the door open for a future agreement with OPEC but also said that they could raise output by as much as 500,000 bbls/day in the near future.
What the Experts Are Saying:
If you watched any of the news outlets, you may have heard of the Goldman Sachs letter dated March 8th. OPEC and Russia started an oil price war that “could push crude oil prices into the $20’s”, according to Goldman Sachs. Damien Courvalin, managing director at Goldman wrote in this letter “we believe the OPEC and Russia oil price war unequivocally started the weekend”, they said, “The prognosis for the oil market is even more dire than in November 2014, when such a price war last started, as it comes to a head with the significant collapse in oil demand due to the coronavirus.”
IHS is saying that oil demand could fall by the most in history (by as much as 3.8 million b/d in the 1st quarter of 2020 alone). This would be even more than during the 2009 financial crisis when it fell by 3.6 million b/d and would be the largest contraction in history according to IHS Markit. “This is a sudden, instant demand shock — and the scale of the decline is unprecedented,” Jim Burkhard, IHS Markit head of oil markets, said in a release. They attribute most of the drop due to stoppage in Chinese economic activity but they expect demand to also be down globally. Lower oil demand is expected in 2020 as compared to 2019.
What this Means for Oil and Gas Companies in the US:
In the 1990’s, crude oil prices were depressed for more than a decade with crude oil trading in the teens to low 30’s per barrel. The difference between the 1990’s and now: the lifting (operating) costs are higher. In the 1990’s and early 2000’s production was mostly from conventional oil and gas wells that were cheaper to drill and operate when compared to the unconventional oil and gas wells that make up most of production in the United States.
The reality is that Oil and gas companies are losing money at current oil prices. For example, OXY had said in an August 2019 Investor Presentation that even with their hedging program, their 2020 breakeven price is in the “low $40 WTI range.”
Diamondback Energy came out saying they are cutting spending to try to stay within cash flow. I expect that other operators will follow suit. It is the only way they will survive.
To try to understand what will happen to us shale producers at these low prices, let’s take a look at Diamondback specifically. According to their latest investor presentation their BEFORE TAX unit operating costs are $24.20 per BOE. This includes lease operating expenses, transportation, overhead, depreciation, and interest expense for their debt. This excludes production and ad valorem tax (severance tax) which is an additional 7% of revenue. Assuming they only produce 300,000 boe/d (below the guidance of of 310-325 Mboe/d they provided in February), and assuming oil price of $25/bbl, this would be an additional $1.75/boe in expenses. So, after tax operating costs would likely be closer to $26/boe and this assumes they make $0 income in 2020 so don’t have corporate taxes above this.
These break-even prices are probably still a bit optimistic but let’s say they are right. If so, this would mean that at prices below $26/boe they would need to shut-in production to avoid the risk of running out of cash.
OXY announced on March 10th that they are reducing their dividend and slashing capital spending for 2020 due to the “sharp decline in global commodity prices”. Vicki Hollub, OXY’s President and CEO said “these actions lower our cash flow breakeven level to the low $30s WTI, excluding the benefit of our hedges”. Which brings me to my next point.
Companies that come out saying that it is not as bad as it seems because they have hedged production through 2020 may be just delaying the inevitable. If prices stay depressed into 2021 then those companies will be in real financial trouble as well.
We may see weaker companies forced into bankruptcy in the short term. In the long term, even some companies with significant production hedged in 2020 may be in trouble if the low oil prices extends into 2021 and beyond.
We could be entering into another prolonged period of low oil prices. I hope I’m wrong and the global economy bounces back from the coronavirus faster than this.
History Repeats Itself
First, let’s compare what is happening now to the downturn in oil and gas markets in 2015. Then, the fundamentals of the overall US economy were good. In fact, some of the pressure on the oil market was due to the strong US dollar (because commodity prices are usually in dollars and fall when the US dollar goes up). In 2015, OPEC also wouldn’t cut production to stabilize oil prices. In the meantime, US oil producers increased production to over 9.3 million bpd. The global economy was weakening (China and Europe specifically), and there was an increase in crude oil production from Iran due to reductions in western sanctions.
So like Yogi Berra said: “It’s like déjà vu all over again.” When you fast forward to today, the overall US economy is good, the dollar is strong, OPEC is refusing to cut production, the global economy under pressure due to the coronavirus, and this time it is the Saudis and Russians who are increasing production. All the while, US oil and gas producers were saying (at least before this week) that they were going to keep production flat or would grow slightly.
If history continues to repeat itself, I would expect oil prices to remain depressed for the foreseeable future. We need to see a sharp decline in supply as well as a recovery in the demand for crude oil before oil trades higher than it is today. Specifically, we would need to see significant cuts from OPEC AND US shale producers, along with decline in coronavirus cases and resumption of economic activity before order is restored.
This is going to put a lot of financial pressure on operators, especially those that are highly leveraged. Like we talked about in 2019, there were already companies that were under pressure when oil was at $50/bbl and that only companies with a strong balance sheet would survive. Many companies have a lot of debt and they will have a hard time making required payments at low oil prices if they are not hedged. No bank in their right mind is going to lend money to producers right now looking to refinance, it’s throwing good money after bad. Companies that even companies that have hedged production for 2020 and that have debt coming due in 2021 are going to feel the pain if oil prices don’t recover by then. This is because they are going to have to hedge the majority of 2021 production at lower prices based on where oil is trading in 2020. So I think we will see a few more small operators go bankrupt in 2020, with the next big wave coming in 2021 unless the market recovers by then. Now this assumes that private equity doesn’t come in to take over that debt. I could be wrong if private equity money comes in to save the day. At the end of the day, I would expect to see some consolidation with stronger companies gobbling up their weaker competitors. Also, I expect that large integrated oil and gas companies will be able to weather the storm, they’ll have profits from refining and chemicals operations to offset losses in exploration & production.
Silver Linings Playbook
If you can see through the clouds, there is a silver lining to the collapse in oil prices. If US oil producers slash capital budgets in 2020 and there is a sharp reduction in drilling new wells, this would mean that less associated natural gas would be produced (most oil wells also produce natural gas as a by-product). Goldman Sachs equity research analysts led by Brian Singer said “We estimate if our covered producers invest on the basis of $30-$45/bbl WTI over the next five quarters, we will see more than 1 BCF/d net less US gas production”.
Natural gas prices were as low as $1.610/MMBtu just a few days ago but the April Nymex futures contract was up 7 cents at the beginning of this week to settle at $1.778. This optimism continued and as of March 10th, the price of henry hub natural gas was up almost another 5% to $1.91.
This will help operators in gas centric plays like the Marcellus and Utica in Pennsylvania, West Virgina, and Ohio as well as in the Haynesville in Louisiana.
What this Means For the Mineral Rights and Royalties Market
All that said, when you look at the value of mineral rights and royalties, there are several things that come into play:
- Commodity Prices. Obviously if oil is at $25/bbl you are going to get half the royalty payment vs. if oil were at $50/bbl.
- Timing of New Production. Due to the time value of money, for undeveloped minerals, the value is based on when the new production is expected to come online. If a company had classified acreage as proved undeveloped reserves (PUD) and had plans to drill wells to produce these reserves within the next 5 years, the value of the underlying minerals was priced accordingly. Now with oil prices in the $20-30/bbl price range, some of these reserves may not economic to develop so companies may be forced to write down these reserves. This pushes the timing of when these reserves will be developed WAY out into the future. So, when a mineral buyer is looking at valuing undeveloped acreage without near-term drilling activity, they are going to forecast new production well out into the future which results in a very low value when these future cash flows are discounted back to today.
- Operator Viability. If you have minerals under an operator whose financial health is in question, this will also have a negative impact on value. This is because a buyer would not expect them to be able to develop the acreage, or even worse, if it is producing that they may shut-in production.
In short, I would expect the market for mineral rights and royalties to remain depressed as long as the price of oil stays low.
Having just said that, there may be a few exceptions to this. If you have minerals where there still is drilling and completions activity, the timing pressure may not be as big of an issue but you are faced with buyers forecasting lower oil prices and hence lower royalties so the value of that property would be lower today than it was 6 months ago.
Also, some drilling activity may continue but only to the extent that it would be more expensive for a company to buy oil/gas on the spot market to meet their contract commitments vs. spending the money to drill a new well. There may be a very few bright spots where a few companies can still make money on incremental production in low cost conventional plays but that would be the exception not the rule.
The moral of the story is: if you don’t need to sell, then hold on to your minerals and royalties and weather the storm. It may be several years before prices recover but the fact remains that our society depends on fossil fuels for our way of life.
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