A follow up on oil prices
A follow up on oil prices and the information we have gathered…
The following piece will help to shed light on the ‘spot’ price of oil and the ‘forward’ price of oil and how they are used by businesses. Secondly, we summarize commentary from various energy related companies and management plans for a low oil price environment. At Mosaic Pacific Investment Advisors, understanding how a company generates revenue and what impacts that cash flow is a crucial part of our investment process.
Crude-oil prices continue their volatile spiral downward. Most of the volatility is experienced in the immediately tradable price of oil, also known as the ‘spot’ price. A helpful way to remember this; it represents the price of oil you can buy or sell ‘on the spot’. The other side of oil prices is referred to as the ‘futures’ price. This price is determined by the expectation of the price of crude-oil at some date in the future. Many companies that buy or sell crude-oil, and its related by-products use oil-futures to reduce the uncertainty of their business. This is also known as ‘hedging’ the price of oil.
Who uses oil futures?
Some companies use crude oil as an input into goods/services sold (ex: Refineries use crude oil as an input to produce gasoline sold at the pump). Let’s call them the future-buyer (fb). In this case, a decline in crude oil can be good for their business as the cost of goods sold declines. And some companies explore and produce crude oil from the ground or ocean rigs and sell crude oil as an end-product. In this scenario, lower global crude-oil prices directly impacts the revenue these exploration companies receive for their work. Let’s call this company the future-seller (fs).
The future-buyer (fb) would like certainty in the cost of a critical input (expense), crude-oil, as they look forward to a gasoline deliver in June of 2015. Remember, they refine crude oil in order to produce gasoline. As such, they need to purchase crude-oil in the future, and refine it, to make good on the delivery of gasoline.
The future-seller (fs) would like certainty in the price received of 100 barrels of crude oil that will be extracted from a project 6 months from now. This company has invested money in equipment and labor into the project and would like to ‘hedge’ a potential decline in the price of crude-oil from current levels.
What if the two parties were both content with a delivery price of $67 per barrel of crude oil 6-months from now? This is what we refer to as the futures price of oil.
The future-buyer (fb) is willing to pay $67 in exchange for 100 barrels of oil to be delivered in June of 2015. Management does not want to risk the chance of a rebound in the cost of crude oil (an expense for them), and ‘locks-in’ the expense.
The future-seller (fs) delivers 100 barrels of oil and in exchange receives $67 per barrel. Management received certainty in the amount of revenue they received for the crude oil extracted from the project.
In both cases, the companies received price certainty in a crucial component of their business.
Management Commentary
Two crucial pieces of our analysis into the attractiveness of energy companies within a lower-priced oil environment is to understand how the company has or has not ‘hedged’ oil prices, and to gather management discussion of business plans should prices remain low. Over recent days, we have reviewed numerous management earnings transcripts from phone conferences. These transcripts are publicly available and offer helpful insight. The following are my notes from the readings.
Devon Energy, Unidentified Company Representative: They do not expect a change in strategy as the long-term prices are not much different from price levels when they developed the strategy. The change in the spot price has not really affected their view of what they may do. The have over 50% of production hedged at $91/bbl. They are focused on oil prices at the end of 2015, ’16, and ’17.
Exxon-Mobil, CEO- Rex Tillerson: Noted that the company can weather oil prices as low as $40/bbl, and that their natural gas and deepwater drilling projects are decade long investments. As such, they have stress-tested profitability of such projects at a range of prices from $40 to $120. Noted that lower oil prices will force out smaller and unconventional U.S. oil companies.
Conoco-Phillips, CEO- Ryan Lance: In regards to acquiring other energy companies, noted that they do have balance sheet capacity ($6 bln in cash), but they have a strong inventory of existing opportunities. Noted that the price environment does not change the way they feel about the dividend. Noted a cost of supply of just below $40/bbl; one of the best in the industry.
Conoco-Phillips, CFO- Jeff Sheets: There will be some flexing in response to short term oil prices as seen in their capital program. Noted that breakeven for existing oil sands operations is $16/bbl, however, for new investment to start a project that number would be in the mid $60/bbl.
Oneok, CEO- Terry Spencer: Noted natural gas pricing remains narrow in the lower price environment. Expect the lower price environment to remain through 2015, which will impact their net realized prices for natural gas, and liquids. However, they do not anticipate the prices to result in reduced drilling activity in the basins in which they operate. They noted project breakeven prices at the following levels; the Bakken $45-60/bbl, Powder River $50-65/bbl, and in the SCOOP $60-70/bbl.
Linn Energy, CEO, Mark Ellis: Noted that the company is 90-100% hedged on natural gas production in 2015 and 2016. They are approximately hedged 60-70% in 2015, and 50-60% in 2016 for oil production. As of November, the company has done well to deliver operating costs below guidance.
In Summary…
My goal from surveying various energy companies was to gain perspective on current sentiment as well as management plans for spending and production. At the moment, it appears most companies will suffer some revenue declines in light of the oil price decline, however, are well-hedged into most of 2015. It seems most of the price movement from energy stocks are attributed to irrational investors and overreaction to movements in the price of crude oil. Further, some companies are in strategic position to pick up market share should other companies cut spending or face a credit crunch.
It is at times like these that the words of Warren Buffett explain it best, the hysteria created by second-by-second stock quotes that we receive on television and our mobile phones. Here is an excerpt from his 2013 Shareholder letter.
“There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.”
Cory Michael Nakamura CFA, CFP®
Chief Investment Strategist and Financial Advisor
CFA Charterholder
CERTIFIED FINANCIAL PLANNER™ professional
Honolulu|Hawaii
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