The price of oil has been steadily approaching the $100 per barrel mark. While this might seem like a windfall for crude producers, the reality is quite different. The oil futures curve is experiencing a phenomenon known as "backwardation," in which near-term front-month prices are significantly higher compared to future prices.

Despite this, oil stocks have performed relatively well. The Energy Select Sector SPDR exchange-traded fund (XLE) has gained an impressive 17% since late June, surpassing any other sector during this period. However, the front-month price of oil has surged by nearly 40%, rising from the high $60s per barrel to a recent price of $93. The issue lies in the fact that the current front month contract for West Texas Intermediate crude oil, which is the November contract, is set to expire on October 20. The December contract reflects an oil price of $90.50, while January's contract shows a price of $88.50. These figures indicate a greater decline in oil futures prices in the upcoming months compared to what is typically observed.

The unusually steep premium for spot oil over futures can be attributed to various supply and demand factors in the market. Saudi Arabia and its oil cartel allies have intentionally limited production in order to drive up prices. Additionally, there is an excess of oil storage capacity at the Cushing trading hub in Oklahoma, where WTI crude is priced.

According to Doug Leggate, a US oil and gas analyst at BofA Securities, whenever Saudi Arabia faces no competition for market share, it takes measures to maintain price levels. However, this artificial price support creates a situation where backwardation becomes a permanent feature of the futures curve. Therefore, while oil prices above $90 have undoubtedly benefited the short-term free cash flow of the sector, the long-term prices remain depressed due to an overabundance of spare capacity. This poses a significant challenge to valuations in the industry.

The Future of Oil Prices: A Market Analysis

BofA commodities strategists have projected a long-term price estimate of $80 a barrel for Brent crude, the international benchmark. This comes as a stark contrast to the current trading price of around $96 a barrel. According to both strategists and futures markets, it is widely agreed that oil prices will not remain at their current high levels indefinitely.

The implications of higher prices today compared to expected future prices are significant. Energy stocks are not being fully credited for the rise in spot, or current, oil prices. This situation favors producers who have the capacity to actively drill or frack oil at present, as well as those with the most productive short-term uses for their cash flow. One such company that stands out in this regard is Occidental Petroleum (OXY), a favorite of strategist Leggate.

Occidental has taken a proactive approach by utilizing its excess cash flow to pay down the $10 billion in 8% preferred stock it issued to Berkshire Hathaway in 2019 for the acquisition of Anadarko Petroleum. This financing method, although expensive, will benefit Occidental in the years to come as it utilizes its current cash windfall to reduce its debt burden. Moreover, Berkshire Hathaway has been steadily increasing its stake in Occidental and now holds 25% of the company.

Leggate is optimistic about Occidental's positioning within the market. He believes that Occidental is best positioned to take advantage of the current strength in oil prices, thanks to its capital efficiency, deep drilling backlog, and the support provided by Berkshire Hathaway's "put" option. This combination of factors also helps to mitigate potential downside risks, should any concerns raised by the commodity team materialize.

Occidental's strategic moves are certainly an example of playing the long game.

Post a comment