Vantage Point Advisors’ Energy Blog July 2021

CAPITAL DISCIPLINE: The Market Rewards Companies for Not Investing as Prices Go Higher

As discussed in previous months, a recurring theme in today’s energy landscape is the concept of capital or “capex” discipline.  As seen in the historical boom to bust cycles in the energy space, as oil and gas prices increase new entrants begin to drill, driving up the cost of rigs and completions, until at some point supply exceeds demand and prices fall to a new point of equilibrium.

Today, many publicly traded exploration and production (E&P) companies have committed to capital discipline, i.e., only committing capital created from operations to new drilling, thereby (hopefully) smoothing and extending the profitable side of the typical cycle.

A recent analyst report from Credit Suisse[1] presents the following three charts as support for the narrative of capex discipline being promoted by E&P companies.

WTI Oil Prices vs. Total US Oil Rig Count

As shown above, for the past decade the rig count and oil prices have moved in tandem. Since the beginning of 2020, the rig count increase has failed to keep pace with the increase of oil.

WTI Oil Prices vs. Monthly Well Completions in Top Four Oil Basins

As shown above, well completions show a similar correlation over the past ten years with oil prices, but again have failed to keep up with the run-up in prices over the last twelve months.

WTI Oil Prices vs. Monthly Drilling Activity in Top Four Oil Basins

The reduction in drilling activity, directly related to rigs in use, also shows a marked departure from historical trends. As prices continue to rise, market participants will be closely watching the “capex discipline” of E&P companies, as compared to the traditional rationale of creating value for shareholders by investing capital in positive NPV opportunities.

WTI Strip Prices Increase

Even with this week’s decline around OPEC talks being postponed, spot prices and near-term futures prices for the WTI contract increased by over $6.00 per barrel from the previous month.

The oil price curve remains in “backwardation” reflecting the market’s expectation of lower spot prices in the future.

Oil Price Outlook

The price distribution below shows the crude oil spot price on July 6, 2021, as well as the predicted crude oil prices based on options and futures markets. Blue lines are within one standard deviation (σ) of the mean, red lines are within two standard deviations.

 

Based on these current prices, the markets indicate there is a 68% chance that oil prices will range from $58.00 and $84.50 per barrel in mid-October 2021. Likewise, there is roughly a 95% chance that prices will be between $40.00 and $107.50. By mid-December 2021, the one standard deviation (1σ) price range is $54.50 to $86.50 per barrel, and the two-standard deviation (2σ) range is $34.50 to $112.00 per barrel.

Key Takeaways

Remember that option prices and models reflect expected probabilities, not certain outcomes, but that does not make them any less useful. If someone asks you longingly if oil will be over $85 per barrel again soon, you now can respond with “the markets indicate there is a 16% probability that oil prices are expected to rise to $86.50 per barrel by this December, meaning $85 per barrel oil is looking more attainable.”

 

For more information, contact:

Gregory E. Scheig, CPA/ABV, CFA, CMA
Vantage Point Advisors
Managing Director / Energy Practice Leader
Certified Mineral Appraiser
180 State St., Suite 225, Southlake, TX 76092

214.254.4801

gscheig@vpadvisors.com

[1] US Crude Oil Production Outlook, Closer Look at Recent D&C Trends and Private E&P Activity; EIA/IEA Still Appear Too High on 2022 Oil Growth, Oil & Gas Exploration & Production | Sector Forecast, 17 June 2021