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Oil and Gas Investor Magazine

[Editor's note: A version of this story appears in the February 2021 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

For all the reasons to say a hard goodbye to 2020 and a hopeful hello to 2021, the dramatic saga of WTI racing to the bottom and below and back to a respectable $50 again is on the short list of hoorays. It’s just enough to make a whole host of operators breathe a collective sigh of relief and revisit those early year capex projections.

Only don’t get too comfortable at $50 oil just yet. The global oil industry can thank OPEC—and Saudi Arabia specifically—for this latest uplift in the oil markets. The effect of earlier OPEC production cuts along with the promise of an imminent vaccine for the COVID-19 supply destruction problem sent prices off the $40 floor and closer to $50 by year-end. Then just when OPEC-plus-Russia decided to begin loosening production constraints by 500,000 bbl/d, potentially softening prices, the Saudis surprisingly announced they would voluntarily and without conditions pull an additional 1 MMbbl off the market for February and March.

Who doesn’t love that? Hello $50, finally again. Pull those rigs out of the mothballs.

But hold the capex increases. A word of warning: Depending on OPEC and Russia for your profit margins is a risky business. They don’t have your best interests at heart. Former Parsley Energy CEO Matt Gallagher said it best in the company’s fourth-quarter 2019 conference call a year ago in February: “Allocating growth capital into a global market with artificially constrained supply is a trap our industry is falling into time and time again.”

A trap. That was merely two weeks before OPEC and Russia got cantankerous last March and subsequently flooded the market, sending prices crashing. That “artificially constrained supply” is once again the problem. It may always be the problem.

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Helima Croft is head of global commodity strategy and MENA research for RBC Capital Markets. In a note following Saudi’s surprise announcement, she said Saudi prince Abdulaziz pulled “a big boss move” with the announcement of a gift to the oil market while the world is facing demand uncertainty due to expanding COVID-19 shutdowns. This even while Russia was allowed to increase supply. However, she added, “We suspect that there may be other intended recipients and that today’s action may be designed to serve broader strategic priorities.”

Which means Saudi can add supply as quickly as it pulled it when it fits their strategic priorities. What happens after March? “This rally has got legs,” said Rystad’s head of oil markets Bjornar Tonhaugen, “but the real question is when will it run out of steam?”

Despite the upward trend of WTI in recent weeks, American producers seem to be holding their enthusiasm to bank on the bigger number. In a survey conducted by the Dallas Federal Reserve of oil and gas companies in December, almost three-quarters responded they were using a price between $40/bbl and $46/bbl for capital planning this year, with $45 at the median. That’s a conservative number to plan around, but lower would be better. Just to be safe.

“Most companies are starting to budget and tailor their programs around lower prices than what they did a few years ago,” Capital One analyst Phillips Johnston said an interview last fall. “The industry has been subsidized by OPEC cuts for a while now, and these companies are starting to get the message and are retooling their investments for lower mid cycle prices.”

Driving down the cost structure to weather price shocks is critical to long-term survival—along with aggressive debt reduction. Johnston views $45 as that sweet spot, as any sustained price below that diminishes the investment needed to keep global production
level, he said.

In December, BloombergNEF reported U.S. oil producers in 2020 reduced breakeven costs by $11.50 per barrel compared to the previous year. “BloombergNEF estimates producers lowered their average breakevens by almost 20%—from $56.50 per barrel in 2019 to $45 today,” the firm said. “In the most productive oil regions (the core of the Permian and Eagle Ford plays), breakevens declined from an average of $44 per barrel to $36.50.”

Raymond James analyst Marshall Adkins, in August when WTI stood at $39, predicted $50 oil by year-end, and it came true. He also predicted $80-plus by year-end 2021, largely predicated on post-COVID-19 world demand and OPEC constraint. That would be nice, but that prediction could unravel for both reasons stated. The price could just as easily see $35 again. If COVID-19 continues to squash demand. If Iran’s barrels come back on the market. If OPEC and Russia decide to open the spigots just a tad more.

$50 is nice for now, but as the Saudi prince in-charge noted, it is a gift. And that gift can be withdrawn any time it’s in Saudi Arabia’s strategic interest. Plan accordingly.