First oil

A bank is a place, where they lend you an umbrella in fair weather, and ask for it back when it begins to rain.—Robert Frost.

Money is the commercial grease that drives our oil and gas industry. Through a variety of financial instruments, Wall Street has been incredibly generous, as well as intensely capricious, to our industry.

Snakes and ladders. Since the mid-1980s, oil-exporting countries have adopted a market-linked pricing mechanism. Commodity traders now set market prices through their futures trades in WTI, Brent and NYMEX contracts. These prices are based on the gap between supply and demand volumes … as interpreted by the commodity traders. It is a question of perception; not unlike deciding whether a glass is half-full or half-empty.

Typically, traders amplify signals from market players in either a positive or negative direction. The run-up in crude oil prices to $150/bbl in 2008 was the result of traders’ perception of growth in demand from China and India. The rapid decline in prices during 2014 was the result of traders’ negative perception of supply exceeding demand (about 1.5 MMbpd) and Saudi Arabia’s decision to defend its market share by continuing to produce above 10 MMbpd, while discounting its prices by a few cents to Asian markets. WTI crude oil prices sitting above $90/bbl for about five years, during 2009-2014, can be seen as unrealistic, as is the price at $48/bbl in late July after a $10/bbl drop in response to the announcement of a pending nuclear accord with Iran. So, with the continuing price decline, traders are now taking away the financial bonanza that they had given earlier to the industry.

Other people’s money. With its inclination to chase high gains despite high risks, private equity funding has been a major contributor to North America’s shale successes. Most recently, private money has invested as much as $44 billion with independent operators over the last year, in hopes that oil prices will recover quickly. Prices haven’t recovered, but the cash inflow has certainly helped many shale operators delay potential doom. If the shale operators manage to hang on through the downturn, their private equity partners stand to gain when the demand picks up. The question remains, whether these fast-buck artists have the patience to wait for a crude oil bull market.

Hedging helper. The recent growth in hedge funds has helped oil and gas operators protect against a price crash. According to a Bloomberg News report, these funds have provided a $26 billion safety net to some of the shale operators, who had the foresight to hedge their production. While the oil prices were rising, these funds made good money. Now, holding the bag are some of the leading Wall Street institutions—JP Morgan Chase, Bank of America, Citigroup and Wells Fargo. Most likely, these banks already have sold off the hedges to third-party risk-takers. Unfortunately, Harold Hamm of Continental Resources cashed out his company’s hedges in October, betting wrongly on a quick price rebound.

Blue chip benefit. Many of the international oil companies, and some of the large independents, are seen by Wall Street as blue-chip investments. Pension funds and individual investors have acquired oil company stocks for generations and have seen both significant increases in equity, as well as regular dividend yields. In fact, most companies continue to issue dividends, even if the financial results do not warrant it. Hopefully, the majors will not lose their blue-chip status through this downturn, and most investors will see this as a buying opportunity.

Price volatility is a fact of life. A saw-tooth pattern within a narrow band is to be expected. However, roller-coaster swings can have life-changing impacts on companies, as well as investors and employees.

Dear God and Wall Street: Could we have another oilfield boom … soon?  

About the Authors

Pramod Kulkarni

World Oil

Pramod Kulkarni pramod.kulkarni@worldoil.com