I hope you are well. I wanted to provide an overview on how crude oil is priced as a follow up to our natural gas and NGL price episode which is Episode 50. If you haven’t listened to that one yet please do as we go over the details around natural gas prices.
At the end of this episode, we also provide an update on recent activity in the market as it relates to OPEC and the supply and demand crisis that we are currently faced with in March & April 2020.
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Market Volatility
With everything going on in the world today (we recorded this episode April 14th 2020), crude oil prices have been more volatile than ever. In fact, the spot price of crude oil has seen dramatic 1-day changes since March 6th following the OPEC meeting where Saudi Arabia and Russia started the brief price war in response to the falling demand due to the global coronavirus pandemic. Since that date there have been seven price swings of approximately 20% or more which is unprecedented. One of the major factors contributing to these wild price swings is the unprecedented crude oil demand loss combined with unprecedented uncertainty around how long the coronavirus response will be required and how long it will take for the global economy to recover once the all clear is given. In this environment, all it takes is a rumor around production cuts or supply builds for oil price to spike in either direction.
Crude Oil Supply and Demand
Let’s take a step back and talk about the macro view around crude oil pricing. As with natural gas, at a high-level the price of crude oil is determined by global supply and demand. When the global economy is good and both developed and developing countries’ economies are going strong, there is an increasing demand for crude oil. This is because many countries rely on fossil fuels for transportation of people and goods, for generating electricity, for heating, for cooking, or in the summer time for cooling indoor spaces. In this scenario the increasing demand puts upward pressure on crude oil prices when current and near-term demand exceeds supply. Similarly, during down markets when countries are cutting back on spending, people are traveling less, fewer goods are being produced and shipped around the world, then this puts downward pressure on prices (in other words, prices for crude oil drop) this is because there is more supply than is needed to meet the needs of society. That is, supply exceeds demand.
An extreme example of this can be seen today with the dramatic drop in global crude oil demand on the order of 20-30% due to the coronavirus pandemic while supply remained at pre-pandemic levels. This delay in curtailing the supply of crude oil was due to the price war between the Saudis and Russians and their refusal to cut production and due to the lag time between other countries and oil and gas producers shutting in production in response to the falling oil prices.
OPEC Crude Oil Supply
One of the biggest influencers on crude oil price is OPEC (Organization of Petroleum Exporting Countries) which has the largest combined proved oil reserves of around 72% of the global total and makes up around 41% of global oil production (as of 2018). Historically, OPEC has been the valve where spare production capacity has been turned on or off to respond to global demand. In a free market economy, it is usually not efficient for oil companies to develop spare capacity and leave it idle because their goal is to maximize the return on investment for shareholders and to pay back that initial capital investment as quickly as possible.
Now vs. the Future
Like with natural gas, crude oil is traded over several different time horizons from the spot market at current prices or in the futures markets at some date in the future. Like with natural gas, a crude oil futures contract is a contract to buy or sell a specific commodity at a certain price on a specified date in the future. When you hear about companies hedging production, this is what they are doing. Many companies buy futures contracts to sell crude oil in the future at a specified price as a form of insurance for prices dropping below their break-even price. In 2019, many operators hedged a percentage of their production at between $50-$55/bbl WTI which in the current market is looking pretty good. Now, generally these futures contracts are priced at certain trading hubs which may or may not be where they are actually producing these barrels. The Nymex crude oil futures contract is based on West Texas Intermediate crude oil bought or sold at the storage hub in Cushing Oklahoma. The full crude oil futures contract specs can be found on the Chicago Mercantile Exchange website which we will link to in the show notes.
Like we discussed in the natural gas pricing episode, location is a big factor in determining the price of crude oil. In the US, there is the storage hub in Cushing OK where WTI is traded, and there are other regional locations where prices are determined based on local infrastructure capacity and the crude oil specifications.
Pipeline Capacity and Wellhead Price
First, let’s talk about local infrastructure capacity – this is one factor in determining crude oil prices as the wellhead. If you are in a location with bottlenecks in the pipeline infrastructure, in other words, there is more supply than takeaway capacity, it can be more expensive to transport the oil to a major trading hub, then this is factored into the price through what is called a price differential which refers to how much lower or higher the price is as compared to WTI Cushing oil. For example, Bakken crude oil produced in the Williston Basin in North Dakota trades at a discount to WTI due to this and other factors. On April 9th, the WTI spot price was $19.38 and Williston Basin Sweet crude was $13.75 and Williston Basin Sour crude was $9.19. More about what sweet and sour mean in a minute.
The point here is that the actual price received at the wellhead can actually be significantly lower than WTI, depending on where you are since local supply and demand is also a factor. If there is a local over supply of crude oil and tanks and pipelines are full, this will result in lower prices as there is nowhere to put the oil and like I mentioned, trucking it to Cushing, Oklahoma would cost more money than shipping via pipeline so that is factored into the price.
How Different Crude Oil Blends are Priced
One of the other factors that determine the price of crude oil are the specifications. Unlike natural gas which generally has to meet certain specifications in order to be called “natural gas”, crude oil specifications can vary greatly.
For example, there is light sweet crude which has a certain API Gravity which is a unit of measure of the oil’s density as compared to water. Heavy oil produced from tar sands in Canada for example has a lower API gravity and higher viscosity than Louisiana Light Sweet (LLS) or West Texas Intermediate (WTI) which are considered two light sweet benchmark crude oils. The “sweet” part of the light sweet crude moniker refers to the sulphur content of the oil. The New York Mercantile Exchange specifies that crude oil with less than 0.5% sulphur content can be called “sweet”. Crude oil with more than 0.5% sulphur content is referred to as “sour” crude. Sour crude has high levels of Hydrogen Sulphide or H2S which has a smell of rotten eggs and can actually be quite deadly at high enough concentrations so there are more precautions that must be taken around H2S crude oil. Heavy or sour crude oil typically trades at a discount to light sweet crude because more steps are required to process it.
How This Relates to Prices
Now I want to bring this back full circle to the current market for crude oil in April of 2020 and the current situation that US oil and gas producers are faced with today. Justin, can you talk about some of the issues between OPEC and US shale producers.
Like we mentioned, in the past OPEC effectively was the valve where spare capacity could be brought online or shut-in to help stabilize prices due to changes in demand. Over the past decade and especially in the past 5-years, US shale producers have effectively come in to fill part of the global crude oil supply gap. This is because onshore unconventional wells can be drilled and completed in a matter of months at a fraction of the cost of a large offshore crude oil development, which can take years to bring online and cost billions of dollars.
Even for these fairly short time horizon unconventional wells, companies rely on stable crude oil prices to base investment decisions on so that they can pay back the initial investment in a certain time frame. The issue that many producers are faced with today is that new wells that are currently in their business plans were based on oil prices of around $50/bbl that just aren’t economic to drill with $20 WTI prices.
But What if They’re Hedged?
Many operators may be hedged and have futures contracts where they have committed to selling a certain percentage of their production at set prices which may help with this. Normally, these hedges can make up for any dips in the price of crude oil. One of the issues that many operators are facing right now is there is just no where to put the oil as storage is already nearly full. This results in a higher price differential to WTI and even this has to be subtracted from the hedge price since they have to be able to deliver the oil to the designated pipeline or storage facility which in this case is more difficult since there is not capacity in the system to do so. So even companies that have hedged a significant percentage of their production at $50 or $55/bbl, may only be receiving $35 or $40 for these barrels due to these higher price differentials. In this case it may put any new production below the break-even price to where they need to delay the investment.
Light Sweet Crude Glut
Compounding things even further, buyers can be very picky as to the API gravity and other specifications of any crude they are willing to take in the current market. This is due to the glut in light sweet crude oil in the US and the fact that many refineries are designed around a specific blend of crude oil.
According to the American Petroleum Institute, “numerous U.S. refineries have invested in complex refinery units to process slates consisting primarily of heavy, sour crudes efficiently into gasoline, diesel jet fuel and other high valued products. Adding light, sweet crudes to the input slates for such refineries increases their crude oil input costs, but does not necessarily provide a significant enough improvement in valuable product yields to be profitable.”
Operators Shut In Production
So, what does this mean for oil and gas producers in the US right now? It means that they are likely going to stop drilling new wells (or at least stop completing them) until prices recover above their break even price. Local oversupply situations may force some operators to shut-in some existing production as well if their cost to produce is higher than what they are receiving for these barrels. They are going to have to take into account leasehold obligations so that they don’t run the risk of leases expiring so there will be certain wells that keep producing in order to hold leases. Also, it may actually be more cost effective for some companies to monetize their hedges (in other words, sell them) if the local price differentials are too high to where it becomes un-economic to produce these barrels.
What this means is that companies are likely in the planning stages right now as to what production they can shut-in while still meeting required debt payments and other contractual obligations while minimizing losses. This is why a strong balance sheet is paramount for companies to weather this storm. In other words, more cash and less debt will help them stay in business during these difficult times.
Historic OPEC+ Supply Cuts
The supply cuts recently agreed by OPEC and the G20 countries are the tip of the iceburg. I expect that US shale producers will actually end up cutting more production than originally discussed in protential supply cuts as part of any OPEC agreements. The historic 9.7 million barrel per day supply cut agreed to by OPEC and other oil producing allies is just the beginning. That massive cut only accounts for around 10% of global demand and there are reports of global demand for crude oil having dropped by more than 30% due to the Coronavirus and associated actions to limit the spread.
How Much is a 30% Supply Cut in the US?
Given the fact that some producers are already starting to shut-in production, analysts are projecting a 2-3 million barrel per day production curtailment. If you consider the fact that the US produced 12.74 million barrels per day in January of 2020, a 3 million barrel per day drop would be around a 23.5% drop in production from January. If producers cut production by 30% or 3.8 million barrels per day, this would bring us down to a production rate of around 8.9 million barrels per day. Only time will tell exactly how low this number will go but the fact remains that a major supply re-balancing is required to restore crude oil price stability until economic activity recovers from the Coronavirus. At the end of the day, low oil prices will force operators to shut in production so I would expect that this aspect of our free market economy here in the US will actually help balance supply and demand to a certain extent.
Will the US Commit to Crude Oil Supply Cuts?
It remains to be seen how much the US will actually commit to in terms of global supply cuts and whether or not they actually formally ask producers to cut back production. It probably would only be a symbolic gesture as many of US operators are going to cut production anyway since it makes the most sense from a financial point of view. It might go a long way in helping to stabilize prices if the US commits to certain cuts that are going to happen anyway.
