The market landscape underlying oil and gas–focused investments has been shrouded in optimism recently, which is supported by the following developments:
- Oil prices have posted strong growth year-over-year, from mid-$40 per barrel observed in early to mid-year 2017 to $60 to $65 per barrel in February/March 2018.
- A recovering European economy has resulted in a stronger euro-to-dollar rate (i.e., $1.23: $1.00 conversion, up from $1.08: $1.00 in summer 2017), which means crude consumers overseas can buy oil cheaper today, on a relative basis, than they could through much of 2016 and 2017.
- The International Energy Agency, a world-leading provider of energy-related statistics and best practices, also estimates 99.1 million barrels of oil per day will be consumed worldwide in 2018, which, if true, will eclipse the oil consumption in 2017 and 2016 of 97.8 million and 96.2 million barrels per day, respectively.
In view of these developments, some highly regarded financial firms are bullish on the prospects of oil for 2018. Goldman Sachs Group boosted its six-month price target by 33 percent to $82.50 per barrel oil, and J.P. Morgan increased its 2018 Brent market forecast to a more conservative $70 per barrel. Despite these bullish sentiments, for a number of reasons we believe 2018 should be viewed as a time for cautious optimism, when considering both traded and nontraded energy-related investments that focus on upstream and midstream activities. Although oil prices have room to increase to an $80-per-barrel level in upcoming years — i.e., the “new normal” price for crude prior to the market crash in late 2014 and early 2015 — a number of factors exist that warrant a more cautious outlook.
REASONS FOR SKEPTICISM
While oil demand is expected to grow worldwide by 1.3 percent in 2018, U.S. shale producers have their foot on the drilling/production gas pedal, so to speak. According to production statistics provided by the U.S. Energy Information Administration (EIA), oil production from 2014–2016 averaged about 9 million barrels per day. In the wake of a more stabilized market environment in 2017, however, U.S. producers’ comfort zones improved, and the domestic production level rose (i) to an average of 9.265 million barrels per day through the first 11 months of this past year (a 3 percent increase over the preceding three-year daily production average), and (ii) to an average of about 9.718 million barrels per day from September through November 2017 (an 8 percent increase over the preceding three-year daily production average). Currently, U.S. production looms at more than 10 million barrels per day, with sentiment that production levels could creep to 11 million barrels per day by the end of this year. Given that many basins in the United States are economic at $30 to $50 per barrel, the motivation for domestic producers to drill remains quite high.
In addition to the rise in U.S. drilling activities, there continues to be an unprecedented level of drilled but uncompleted (DUC) wells within various basins. Nationally, the EIA estimated 7,493 DUC wells at year-end 2017, 2,274 wells more than what was reported a year prior — a 44 percent increase in DUC inventory year-over-year. By region, the Permian Basin accounts for the highest percentage of DUC-well inventory at 2,777, followed by the Eagle Ford Shale Play at 1,468, and the Oklahoma STACK/SCOOP Plays at 1,022 wells. In view of better oil prices, coupled with the general sentiment that U.S. and worldwide appetites for crude will continue to increase oil demand, the motivation for domestic producers to complete more from the DUC inventory again remains high.
Quoting the words of an energy executive who attended our annual energy investment conference, “U.S. producers have just gotten too good” at finding oil and gas reserves. Much of this success has to do with the implementation of horizontal drilling in earnest in the mid-2000s and the follow-on improvements that were made to fracking methods used in the completion process over the past few years. While drilling and completion costs per well in general have risen moderately over recent history, much more sand and water is used today to hit the oil- and gas-bearing formations than was used five years ago. As more of the reservoir is now being exposed to the frack and reached, the same has resulted in production numbers that are multiples of what was possible years ago. In light of such technological improvements, more operators can drill profitable wells at lower oil prices.
WHAT MUST GIVE?
The wild card in the success equation for 2018 and beyond is whether the Organization of the Petroleum Exporting Countries (OPEC) will continue to be cooperative in curtailing crude outputs. Over a three-year period from 2014–2016, OPEC increased its oil production from 30.5 million barrels per day to 32.6 million barrels per day. This sent shockwaves into the oil market as the world supply/demand equilibrium was disrupted. In 2017, however, OPEC kept its production stable at 32.1 million barrels per day in the first quarter, 32.3 million barrels per day in the second quarter, 32.7 million barrels per day in the third quarter, and 32.5 million barrels per day in the fourth quarter. This resulted in a slight 0.5 percent drop in oil production year-over-year from what was reported by OPEC in 2016. While OPEC’s production is expected to remain stable for the first six months of 2018, OPEC’s production estimates, at this time, anticipate an increase in daily oil production to about 34.0 million barrels per day in second half 2018.
In the absence of OPEC’s willingness to capitulate to the desires of U.S. producers and to leave production at current levels, the world will most likely need to increase its appetite for crude to sustain oil market prices at or above $60 per barrel. Taking a measure of future supply and demand uncertainty into account, EIA’s 2018 price forecast for oil was last reported in its Feb. 6 Short-Term Energy Outlook to be $58 per barrel U.S. and $62 per barrel Brent pricing. A measure of skepticism about oil’s future prospects can also be observed within the U.S. oil futures markets, with futures contracts on March 5 trading at $59 to $60 per barrel for July through December 2018 and at $56 to $58 per barrel through 2019. While operational profits can be made by a fair number of U.S. producers at such pricing levels (i.e., assuming drilling and completion vendor costs remain relatively constant), time will tell whether the oil-market joyride continues.
SIGNS OF HIGHER INVESTOR COMFORT
Despite the uncertainties, some indicators show investors are moderately more comfortable with energy investments now than they were from 2015 and through much of 2016. In the publicly traded partnership universe, traded MLPs reported a collective market capitalization of about $375 billion at year-end 2017 (up from a low of about $320 billion in 2015), with the Alerian MLP Index being fairly stable at 1,200 to 1,400, after posting a five-year low of 826 in February 2016. In 2017, some degree of positive sentiment also reached the broker-dealer retail investment community, as broker-dealer sales of nontraded pass-through oil and gas fund products we reviewed increased about 10 percent year-over-year — $330 million in 2017 versus $300 million in 2016 (as to the sponsors whose offerings we reviewed). Of this amount, about 70 percent was raised in tax-advantaged drilling funds, with the remainder spread out among diversified opportunity funds and programs that acquire mineral and royalty investments. Of the nine oil and gas sponsors that we track during our due diligence legal engagements, six reported fairly significant increases in capital raised. Still, a full recovery to the $700 million to $1 billion raised in the retail channel in 2007–2008 and 2011–2014 is most likely a few years into the future.
The oil market landscape is like the ocean — you cannot afford to turn your back on it from a due diligence and market-monitoring perspective. At $60 to $65 a barrel, we are in a better oil-pricing environment than we were through much of 2015–2017, but with questions unanswered as to whether the drilling momentum of U.S. producers can be neutralized with OPEC production and/or a growing world economy. Assuming the sentiments of Goldman and J.P Morgan play out, some upside will likely find its way to investors who placed capital in fundamentally sound projects and assets.
We believe cautious optimism is the key to success with respect to oil and gas investments in 2018. Because fundamentals are important, we urge you to pay close attention to the energy companies that have heeded certain lessons after the oil market fall of fourth quarter 2014 and have shaped their business strategies accordingly (e.g., using less leverage, diversifying projects among multiple plays, maintaining sound liquidity, maintaining a balance within critical areas of oil/gas operations, and timing the deployments of capital methodically as opposed to rapidly). Reps and advisers should also be ever mindful of each investor’s allocation to public and private energy investments, given the inherent level of market variables beyond the rep/adviser’s and investor’s abilities to control.
Brad Updike (firstname.lastname@example.org) is an attorney and director with Mick Law.