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Midweek Sector Update: The Worst May Well Be Behind Us

Midweek Sector Update: The Worst May Well Be Behind Us

Oil prices are up, and could continue to see some strength coming from a very unlikely source: Eurozone growth. That’s not a typo. The European Union published a forecast on May 5 that pointed to a higher rate of economic expansion in the months ahead on the back of monetary stimulus and low oil prices. The EU could see growth of 1.8%, an upward revision from its previous forecast in February of 1.7%. That is not exactly lightning-speed growth, but it is a solid performance for the debt-ridden continent that has been fighting off recession. Still, there is a massive hangover from the Eurozone crisis from the last few years – debt, high unemployment, banking fragility, and an unclear path forward. And, ironically, the improved outlook stemmed in part from low oil prices, but a stronger EU economy could contribute to higher oil prices. For the oil markets, a stronger European performance is an unlikely, but welcome, development.

With all of the quarterly earnings in from the oil majors, there is one common thread that runs through all of the reports. Profits from upstream oil and gas production were way down for the first quarter in 2015, but the damage was largely mitigated by downstream refining, which saw a large boost in revenue. Lower oil prices provide a larger margin for refiners to sell their products. But with WTI trading at a discount, refiners earn a little extra – buying crude at a discounted (WTI) price, and selling their refined products at a higher global price (more closely linked to Brent). By and large, the oil majors have their fingers in a lot of pies, and robust downstream operations provide a hedge against lower oil prices. That is not the case with smaller upstream companies that are more singularly focused on extraction. Those are the companies that are clearly hurting much worse. Related: BP Proves Analysts Wrong With Better Than Expected Earnings Report

ExxonMobil (NYSE: XOM) saw its refining profits double even as its upstream activities suffered. BP (NYSE: BP) saw downstream earnings more than double. Total (NYSE: TOT) managed to triple its earnings from refining. And on it goes. Still, overall, profits for all the oil majors are down on balance, but the first quarter performances show the benefits of an integrated business model.

Another strategy that oil producers are using to alleviate the damage done from low oil prices is through financial mechanisms. Hedging their production at stable price levels could keep losses at a certain level, even if it means putting a ceiling on potential profits. Reuters reported that oil producers are stepping up their hedging, locking in prices that allow them to sell oil within a range of between, say, $45 and $70 per barrel. If prices drop below $45, these companies would be protected. Still, that means that they would miss out on higher profits if prices jump above $70. But after a year of extreme volatility, an increasing number of companies find it beneficial to hedge their future production to ensure some stability. Related: Why The US Should Worry About Oil Sector Jobs

Last week North Dakota passed a law that will lower the tax burden on the oil and gas industry over the long haul, but also eliminate a short-term tax benefit for drillers. Under the old law, North Dakota – whose Bakken shale has already seen some production declines in recent weeks as well as a swift drop in its rig count – had a tax rate of 6.5% on oil extraction. But that tax rate would drop to zero in the event that oil prices stayed below $55 per barrel over the course of five months, a policy put in place to help companies during a bust. The state was a few weeks away from that scenario coming to fruition. But the North Dakota government, concerned that its take on oil extraction would disappear, overhauled the law in late April, in the waning days of the legislative session. The law just signed by the Republican governor does away with the temporary 0% tax rate, but in exchange the state dropped its permanent tax rate from 6.5% to 5.5%. The oil industry is split on whether this is a good thing or a bad thing. On the one hand, drillers were set to receive a windfall under the old regime in the coming weeks. Now they won’t. On the other hand, some companies like the stability of a fixed tax rate that won’t change, not to mention the fact that the state has now permanently shaved off a percentage point. Related: We Are Witnessing A Fundamental Change In The Oil Sector

Russia continues to produce oil at a near-record rate. For the month of April, Russia produced 10.71 million barrels per day, a high in the post-Soviet era. The higher production is helping offset the decline in revenues from low prices and western sanctions. The Russian economy shrank by a painful 3.4% in March from the year before. The ruble has taken on a high degree of volatility, interest rates were jacked up to rein in inflation and capital flight, and government revenues have taken a hit. Russian President Vladimir Putin is surely breathing a sigh of relief with the recent uptick in oil prices, a rise of nearly 40% in the last few weeks. Brent is now trading above $66 per barrel, a level not seen since OPEC made its decision to leave its output unchanged last November. Russian officials are set to meet with their OPEC counterparts in early June, with discussions covering the possibility of a coordinated output cut. But there is little scope for Russia to cut back on its production, given the aforementioned economic struggles. Russia declined to cooperate last time around. However, having seen OPEC’s resolve in the face of low oil prices in the intervening months since their last meeting, perhaps Russia will reconsider balking at coordination. 

By Evan Kelly of Oilprice.com

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