Revert to the Mean

The article below from the July issue of Oil and Gas Investor is posted on our site in an effort to help mineral and royalty owners understand the complexity of forces impacting oil prices, particularly the strength of the dollar.

In search of a higher price per barrel, the global oil industry is glued to news of supply and demand. Will Saudi Arabia and Iran play nice and agree to cut (or at least freeze) OPEC production outputs? How many more trucks and cars can China and India add to their roads? When will Canada’s wildfires subside in the oil-sands patch? How many more Nigerian pipelines will militants take out? At what price will U.S. shale rigs begin drilling more?

But simple supply and demand dynamics are not the sole drivers of a barrel of crude. As a dollar-denominated commodity tradable on the world market, the price of oil is at the mercy of a complex tide of economic pushes and pulls. Roger Burks, executive managing director and CEO of energy consulting firm W.G. Consulting, alerts the industry that E&P professionals consistently overlook the effects of the monetary marketplace on the up- and downswings in price.

“E&P professionals focus on fundamentals; they never talk about the strength of the dollar to oil,” he said, “but when you talk to financial traders, they always talk about the dollar.”

This can be dangerous for the financial stability of your company.
In simplistic terms, the strength of the dollar when measured against other currencies has an inverse effect on the price of oil. When the dollar is strong, oil goes low; when the dollar is weak, oil moves higher.

Take the 2008-2009 oil price whipsaw, for example, which had nothing to do with supply/demand. The price of oil rocketed to $140/bbl when the Federal Reserve began desperately dropping interest rates as the global financial crisis loomed. It fell to $36 as traders pulled money out of all markets looking for a safe haven, then rose again to $110 and stayed within a tradable range as the Fed began a long period of quantitative easing (QE), pumping more than $3.5 trillion into the market over five years.

“When you double the amount of money in circulation, the value of commodities priced to dollars has to double. That’s a financial bubble,” Burks said. “We printed enough money to prop up the price at $100.”
QE ended in October 2014, and oil again dropped by half. Of course, in that period, the U.S. had doubled its production, and OPEC members announced they weren’t going to slow theirs.

Yet the spikes and dips in oil prices caused by financial bubbles are temporary anomalies, said Burks. Supply and demand is still the fundamental driver, and the price of oil will always calibrate to an inflation-adjusted mean price based on historical prices. In today’s dollars, that’s $50, plus or minus $10, he said.

“Commodities always revert back to the mean historical inflation on the fundamental supply/demand. Be aware of the strength or weakness of the dollar, and when the numbers don’t make sense, like when oil is at $100 or $30, know that something is not in sync.”

He noted that the average price of a barrel of oil in 2015 was $52, a reset to the historical average. Unfortunately, many E&Ps had leveraged to the upside.

The most recent January price collapse—to $26—had nothing to do with supply and demand, and everything to do with short selling, he said. A wave of second-lien loans put in place in spring 2015 combined with hedges rolling off in 2016 prompted the short selling in oil to hedge against loan defaults.

“Selling shorts caused it to go to $26, and that’s why we’ve had such a quick rebound to the calibrated point of $50 again,” he said.
With inflation flat, producers should plan their businesses to be profitable in an oil price range of $40 to $60, and hedge like crazy should prices spike beyond that.

“Our job is to drive oil and gas production on a long-term basis in a commodity-driven environment with a fluctuating inventory price. You should always hedge out production to cover all capex costs as far as you can. Make your money at your number.”

Burks references some predictions that oil will trend to $70, even $80, by year-end, and doesn’t deny it could happen, although he sees that possibility further out. But at just 1 MMbbl/d of oversupply worldwide, even at 1 MMbbl undersupplied, he questions, “What will drive us to $80, a 60% price increase without a monetary event? What’s going to change?”

Instead, he suggests investing for the downside and focusing on developing assets with the most efficient means possible, “and know that the price is going to revert back to the mean.”

Source: Steve Toon, Hart Energy/Oil and Gas Investor