Covid-19 has disrupted many markets, and because of its overall economic importance, oil prices and costs have garnered a large share of the news spotlight. We at Allied want our partners to have a good understanding of what’s actually behind the headlines, so that’s why we have put this article together, always keeping our eye on R.O.I.
We’ll start with the two costs that are fundamental to Allied and our partners:
- Finding Cost: This is the total cost for developing an oil well. It is the sum of these costs: leasing acreage, evaluating (via geo-seismic technology) the trajectory of recoverable reserves, preparing the site, drilling and completing the well. (We would add to this all customary business, regulatory, and administrative costs when developing joint venture unit pricing.) These are the costs Allied Resource Partners has to pay.
- Lifting Cost: This is sometimes called operating or production cost. Direct lifting cost is the cost we pay on a monthly basis to operate and maintain the well and related equipment. It is often calculated on a per barrel basis. If we add in production taxes, we get total lifting cost. LIFTING COST IS IMPORTANT! THE DIFFERENCE BETWEEN OIL PRICE AND LIFTING COST DETERMINES PROFIT.
Now let’s talk about price. There has been much noise in the news recently regarding oil prices turning negative. That is NOT TRUE at the wellhead.
- The wellhead price is the price we get when selling a barrel of oil. ALLIED WILL NEVER SELL ITS OIL AT A PRICE THAT IS LOWER THAN TOTAL LIFTING COST.
- A recent article highlighting an oil price of minus $37.50 described a Futures Contract Price. A Futures Contract is an obligation to take delivery of a specified quantity of oil at a specific future date and location.
- Futures contracts are used by speculators attempting to make money by arbitraging (buying and selling, never taking delivery). FUTURES CONTRACT PRICE BRIEFLY TURNED NEGATIVE BECAUSE STORAGE (TANKS, SHIPS, ETC.) IS NEARLY FULL. THE GLOBAL ECONOMY, SHELTERING IN PLACE DUE TO COVID-19, HASN’T BEEN CONSUMING OIL BUT WELLS HAVE TO KEEP PRODUCING. THE RESULT: INVENTORY BUILDS. AND IF THERE’S NO PLACE TO STORE IT, FUTURES CONTRACT PRICE PLUMMETS. INDUSTRY EXPERTS KNOW THIS IS A SHORT-TERM PROBLEM THAT THE MARKET WILL FIX.
- The futures market has its own arcane vocabulary regarding price (Contango, Forwardation, Backwardation, etc.) Knowing the details won’t add much, so we won’t bother discussing them.
And that takes us to a final topic: the Oil Market. Like every market, it has two sides: Supply and Demand. Economists tell us that Price and Quantity are determined by the intersection of supply and demand curves. They also tell us how difficult it is to determine them, but they do make these observations:
- Suppliers (oil companies large and small) and consumers (power generating utilities and the public) usually behave rationally, but
- Oil supply is a political football (think OPEC and Russia).
- During a crisis (think Covid-19), suppliers and consumers may react irrationally/emotionally. For the most part, consumers are behaving as expected: oil consumption has declined. And the oil companies are beginning to reduce production. As both sides continue adjusting, oil price will continue swinging. What happens politically is always a wildcard.
Let’s translate all the above into takeaways for Allied and its partners, adding to it those we already know:
- THE COVID-19 PANDEMIC WILL EVENTUALLY GO AWAY. DEMAND FOR OIL AND GAS WILL GROW AGAIN AS THE WORLD ECONOMY COMES OUT OF “SHELTER-IN-PLACE” HIBERNATION.
- OIL AND GAS ARE THE BEST SOURCES OF ENERGY THAT WILL BRIDGE THE WORLD ECONOMY FROM TODAY UNTIL WE REACH A “GREEN/ALTERNATIVE ENERGY” FUTURE.
- IT WILL TAKE DECADES FOR TECHNOLOGY AND ENERGY INFRASTRUCTURE TO REACH THE FUTURE. THAT MEANS O&G WILL BE NEEDED BEYOND OUR LIFETIMES.
- ALLIED RESOURCE PARTNERS, WHEN PREPARING THE FINANCIAL PROJECTIONS FOR A JOINT VENTURE, CALCULATES R.O.I., ETC. FOR A RANGE OF OIL PRICES.
- OUR PROJECTS ARE PRICED SO THAT PARTNERS GET RETURNS BETTER THAN WHAT YOU’LL GET FROM OUR COMPETITORS (OR STOCKS AND BONDS).
- TAX WRITE-OFFS MAKE PARTNER RETURNS EVEN BETTER.
- IF SHORT-TERM PRICE FALLS BELOW OUR LIFTING COST, WE’LL SHUT IN THE WELL UNTIL PRICING IS BETTER.
- ALLIED PARTNER PROFITS ARE DETERMINED BY THE DIFFERENCE BETWEEN OIL PRICE AND LIFTING COST. THEY TEND TO MOVE IN TANDEM.
- ALLIED HAS NO DEBT TO SERVICE. WE DO NOT NEED TO SELL OIL AT UNATTRACTIVE PRICES. WE CAN SHUT IN OUR WELLS UNTIL PRICES RISE TO A LEVEL WE AND OUR PARTNERS LIKE.
- FOR A SMART ACCREDITED INVESTOR, ALL THE ABOVE MEANS THAT IT’S ALWAYS A GOOD TIME TO BUY INTO OUR LIMITED PARTNERSHIPS IF O&G LIMITED PARTNERSHIPS FIT YOUR INVESTMENT GOALS.
We want you to be well informed, because the more you know about O&G, the more you’ll understand why we can say that Allied is leading the way by treating smart, accredited O&G investors the way today’s business climate demands. Please contact us if you would like to discuss further any of the items we touched on above.