Oil Futures Signal Weak Prices Could Last Years

Aug 17, 2015

The oil market is signaling that prices could stay lower for longer, delivering a fresh blow to hard-hit energy exploration-and-production companies.

Benchmark U.S. oil futures for September delivery are nearing the six-year low hit in March. But contracts for delivery in later years have taken an even bigger hit, with prices for 2016 and 2017 already trading below their March lows.

That indicates that investors, traders and oil companies see the global glut of crude oil persisting beyond this year.

Companies making long-term investment decisions rely on the prices of futures contracts one or more years in advance. Producers trade futures and options contracts for coming years to lock in prices for the oil they plan to sell in those years.

A number of U.S. shale-oil producers say they can profitably increase production if prices rise above $65 a barrel. On Friday, front-month oil prices fell 79 cents, or 1.8%, to $43.87 a barrel, while futures for delivery in December 2016 settled at $51.88 a barrel. The most expensive benchmark oil-futures contracts, which were dated for delivery in 2022 and 2023, settled at $63.26 a barrel.

For many producers, such as Diamondback Energy Inc.and Marathon Oil Corp., later-dated contracts are now too cheap to justify locking in prices. That means producers are likely to enter 2016 with fewer price hedges on the books than usual, if they have any at all.

Companies without price protection in 2016 could be forced to cut back further on new drilling if prices remain below their break-even costs.

“I think it’s a fair assessment that just about nobody is putting on hedges at this point,” said Jason Wangler, an analyst at Wunderlich Securities. “Why lock in the bottom?”

The drop in later-dated prices surprised some analysts and investors. Oil trader Andrew Hall, who is known for making long-term bullish oil bets, wrote in an investor letter dated Aug. 3 that he didn’t foresee the “pessimism” in the oil market. Mr. Hall’s $2.8 billion hedge-fund firm Astenbeck Capital Management LLC fell 16.6% in July.

“It was notable that last month’s collapse in prices was led primarily by heavy selling of deferred futures contracts,” Mr. Hall wrote. “The assumption is that prices will be capped for the foreseeable future by the cost of producing shale oil in America.”

Hedging has boosted producer profits this year, as some companies are still able to sell oil at $90 a barrel or higher, prices that they locked in a year or more in advance. Many companies are counting on prices rising from current levels. If the forecast prices indicated by the futures market turn out to be correct, 10 of the largest U.S. independent producers will outspend their cash flow by $11.4 billion next year, according to investment bank Tudor, Pickering, Holt & Co.

Banks review the value of companies’ oil and gas reserves, which can be used as collateral for loans, in the spring and fall. If banks price these reserves based on long-dated futures prices, their value could drop significantly in the coming review, analysts said, shrinking the amount of money that production companies can borrow based on those reserves.

“I think the banks have less flexibility with the redeterminations in the autumn,” said John Saucer, vice president of research and analysis at Mobius Risk Group in Houston, which helps companies hedge. “It’s going to be a tough round this go-around.”

The energy sector of the S&P 500 has fallen 14% since oil prices hit their 2015 high in June, while the broader index is down 1.3% in the same period.

Producers rushed to lock in hedges when prices rallied above $60 a barrel in May, which pushed prices in later years above $65 a barrel. But concerns about Chinese growth and an increase in U.S. drilling sent prices plunging in July. In second-quarter earnings, some U.S. producers announced record oil output.

“We really just were able to begin to establish a position in 2016 before the market kind of fell on us,” said J.R. Sult, chief financial officer of Marathon Oil, in a Thursday earnings call. “Would I like to have more hedges on today? Yes.”

Travis Stice, chief executive of Diamondback Energy in Midland, Texas, said he doesn’t intend to hedge more of the company’s 2016 production unless crude prices rise to $65 a barrel or higher.

Futures contracts for delivery a year or more in advance demonstrate what traders are willing to pay for future barrels. But Still, long-dated futures are typically a poor indicator of where prices are headed.

Later-dated futures prices traded at a steep premium to front-month prices early in 2015 as concerns mounted that some regions would run out of space to store crude oil. But crude stockpiles started to shrink in the spring, as refineries ramped up activity due to robust global gasoline demand.

At the same time, a nuclear deal between Iran and six world powers raised the prospect that with sanctions lifted, Iran would ramp up crude exports in late 2015 and 2016. Reduced worries about storage space and the likelihood of growing Iran output pushed down later-dated prices.

“The companies are feeling more pain today than they did two months ago,” said Will Riley, co-portfolio manager at Guinness Atkinson Asset Management Inc., which oversees about $300 million in energy-equity investments. Guinness Atkinson has cut exposure to highly indebted oil producers.

“They are starting to look forward to the end of this year and into 2016,” Mr. Riley said. “Spending is only going to be increasingly constrained.”

Source: wsj.com