Here comes $75 oil

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This week’s Barron’s cover story is the topic of conversation among energy-sector participants. Politicians are talking about the pain that Russia will feel if oil goes to $75, while economists are talking about how lower oil prices will benefit the U.S. economy. Traders and investors are concerned about the energy sector’s profits and the longer-term energy market outlook if a $75 price is realized.

Clearly, lower oil prices would benefit the consumer. Oil at $75 implies a price of $2.25 for the unleaded gasoline future or about $2.60 for average pump prices in Wyoming. As a rule of thumb, for every 1 cent reduction in the price of gasoline, the consumer has $1 billion dollars more to spend on an annualized basis. This would equate to approximately 0.4 percent improvement in the U.S. GDP over these years.

But for oil producers, $75 oil would narrow margins and make many of the shale and tar sand oil plays uneconomical. Another factor that will negatively impact oil producers is the reduced income from taxes and royalties that many energy-producing entities receive. Russia, Saudi Arabia and states in the U.S. like Wyoming, Texas, North Dakota and California for example, will feel this pinch.

First, let’s understand the reasoning behind the $75 forecast published in Barron’s to see if this price makes sense in the context of the consensus view. From the Barron’s article:

“Amy Jaffe, ED for energy and sustainability at the University of California, Davis, co-authored a recent study with Rice University economics professor Mahmoud El-Gamal predicting that barring a “war that destroys physical installations for the production and/or transport of oil,” the oil price will “fall precipitously over the medium term of three to five years.”

Is this forecast that far away from the consensus view? Not really. I believe that one of the best indicators of what the market thinks about forward oil prices are reflected in the WTI oil futures price. This price reflects the collective wisdom of all consumers, producers, speculators, investors and hedgers as to where the forward price of oil should be.
Why is this the case? Because these energy market participants are willing to buy and sell at this oil futures price. How well the forward prices track the actual realized prices is a different matter. The best investors and traders are the ones who are able to profit from the difference between the future price and the actual realized price. Whenever I speak to a trader or investor, I do not ask what investment they think will go up or down, I ask, “What are your positions?” and from this, determine their willingness to actually make or lose money on a position.
So what is the consensus view?

As you can see in the chart above, the market has already placed the forward price of oil in the $75-80 range. Is this a new development? No. As you can see, the five-year forward price of oil was in this range one and five years ago as well.

In my trading classes I try to teach the students to think for themselves and to try to enable them to get ahead of the conventional wisdom. A game I play is “what if?” What if oil is trading at $75 in 3-5 years? If oil goes from $100 to $75, what assets would do better and what assets would perform poorly over this time frame? The first challenge is to try to figure out which entities would do better and which would do worse if oil declines to $75. Because of the limits to the length of this article, I will focus on the possible impact to Wyoming entities of $75 oil.

Let’s start off with the energy companies in Wyoming. The oil energy and exploration companies should be less profitable if oil drops from $100 to a future price of $75. This drop would also hurt the oil drilling and servicing sectors because they would drill fewer wells in the higher-cost regions. What about natural gas and coal? Does a lower oil price cause these two sectors to go down as well? Let’s look at a chart of the historical relationship between crude oil and natural gas prices (on page 25)

 For many years oil was between three and 10 times more expensive than natural gas. Then the shale revolution started and the spread blew out to 50 times in 2012. Natural gas was $2 versus $103 for WTI oil. So to answer the above question, no, the price of oil does not have as big an impact on the natural-gas market. Why? Natural gas is a domestic market. We do not have the government permits or infrastructure to liquefy gas and ship it to foreign countries. Currently, LNG (liquefied natural gas) is trading at three times the cost of our gas in Europe and Asia. These roadblocks are changing. In the near future we will see our cheap gas shipped to the foreign markets. Do these possibilities impact the forward natural gas curve? Yes, as you can see by the second chart on page 25
You can see from the two charts that the forward price of natural gas is increasing while the forward price of oil is dropping. Also, with the cold winter, our natural-gas reserves have been drawn down to their lowest levels in more than 10 years. If the forward prices are realized, and weather remains a factor, natural gas companies should do better than companies producing oil in this scenario. This would bode well for gas producers in Wyoming like Ultra Petroleum, which focuses primarily on gas production.

Wyoming Powder River Basin coal is more highly correlated with natural gas prices than with oil prices. This is because they produce thermal or steam coal that is used for power generation. You can see this correlation in the following graph:

One of Wyoming’s largest coal producers, Cloud Peak Energy, produces a high percentage of its coal in the PRB. The majority of PRB coal is used for power generation. Another factor that helps support the price of this coal is that many power plants are now able to switch from coal to natural gas and vice versa. This enables utility companies to use the lowest-priced feedstock. Many utilities say that their switch point is approximately $4 for natural gas. If the forward price of natural gas is realized, this too would be supportive of coal prices.

Other potential winners and losers might be states that depend on oil royalties and taxes. Wyoming could potentially limit this loss if the forward prices were realized because close to 80 percent of Wyoming’s mineral revenues are from natural gas and coal.  

If gas and coal prices increase, this should offset the potential weakness coming from oil. Do other states rely more on oil revenues to make ends meet? If so, their municipal bonds might decrease in value if the state’s credit worthiness is called into question.

In summary, if oil drops to $75, producers of natural gas and coal would benefit and producers, as would states whose mineral revenues are generated more from natural gas and coal, than oil. The states whose mineral revenues come primarily from oil might suffer the most.

Let’s briefly talk about the consumer. If the consumer has more money to spend because prices at the pump are lower, the consumer discretionary sector should do well. For example, we might see an improvement in the travel and entertainment sectors. This too could be positive for Wyoming’s tourism industry as well as for those businesses that support that industry, such as food and beverage. Not only do the consumers have more cash, but also travelling costs are lower.

In summary, I offer the following: When prices in your markets change, it is important to understand what is causing those changes, and also what events may reverse those changes. This will not only help your investments, but will also help you manage your other personal finance and business decisions in a more effective manner.

Wyoming Business Report contributor Patrick Fleming is a professor at the UW College of Business. He received his BA in Economics from Harvard and has spent the last 30 years working in Tokyo, Hong Kong, London and New York specializing in global macro and arbitrage investing in the commodity, equity and global bond markets. Fleming is the former CEO of a 77-year old investment firm in New York, and currently teaches energy trading and managerial finance to MBA students and investment management to undergraduates.

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