The price of oil has proven to be remarkably difficult to predict. While the long term outlook is likely to reflect supply and demand, near-term fluctuations have been prone to sharp, often inexplicable price changes.
For at least fifty years, conventional wisdom was focused on the eventual depletion of all known reserves and an ensuing economically significant shortage. These fears seem to have been largely dispelled, as a flood of discoveries and improved extraction technologies have combined to create a significant surplus. A surplus so large that many of the major oil producing countries have agreed to reduce production quotas.
In an environment with little likelihood of a near-term shortage of oil, other factors may provide some insight as to the outlook for oil prices and the oil industry. Perhaps the most important question for oil industry investors is, what is a realistic price for a barrel of oil? The primary answer would be that it depends on supply and demand, as oil tends to be market priced most of the time.
Another factor to consider is determining the break-even price for a specific oil field. Generally, drilling activity reflects the owner’s costs compared to the anticipated selling price. This not always true for government projects, as cash requirements can supersede profitability.
One measure that may prove to be a useful indicator of oil price expectations is rig count. Baker Hughes provides weekly data regarding the U.S. rotary drill count. Historically, there has been a relatively close correlation between rig count and oil prices. The logic is quite compelling, as higher oil prices translate into an increase in potentially profitable drill opportunities.
When looking at rig counts, it is important to also monitor day rates. Day rates, in oil production, are the amount that a drilling contractor gets paid by the oil company for a day of operating a drill rig. Obviously, day rates can fluctuate widely, depending on the drill site (North Dakota is a lot cheaper than the North Sea), the availability of rigs and the type drilling required.
Since last summer, there has been a modest increase in the rig count and some signs of higher day rates, suggesting that current oil prices may be attractive to more oil field owners. Due to the lead times between the start of drilling and well completion, the additional supply has yet to hit the market.
All comments and suggestions are welcome.
Walter J. Kirchberger, CFA®