One Price Does Not Necessarily Fit All

By Michael Toppi, Aspen

There is a view that the generalist can be as successful as the specialist in assessing risk for E&P companies when global per barrel (bbl) oil prices are in the ascendancy and remain consistently above $100/bbl. The precipitous drop in oil prices from the June 2014 peak has undoubtedly proved a tough test for all concerned, not least U.S. surety underwriters.

Since the beginning of the year, many U.S. sureties have begun taking aggressive action in reducing their U.S. oil market exposures. The question is whether such action is justified and will it actually result in the baby being thrown out with the bath water? In other words, as in past underwriting cycles, will good risks and not-so-good risks get tarred with the same brush? Could there be an overreaction in some quarters of the surety market?

Uncertain Forecasts

Chapter 1 of any economics textbook explains that price is dependent on the interaction of demand and supply. So far so good, but oil is a global market and the factors influencing demand and supply are complex and unpredictable—particularly so in the short term when market psychology can be an additional factor. In the long term, supply factors include U.S. shale production and export licenses, OPEC strategy and the impact of specific sanctions and trade agreements (e.g. Russia and Iran). These then have to be set against global demand that, in turn, can be influenced by the prevailing market price.

Demand from drivers in the U.S. during the summer months is one such example as it is relatively elastic: the lower the price, the higher the demand. It is easy to empathize with the view, often attributed to James K. Galbraith, that the only function of economic forecasting is to make astrology look respectable.

Price, Production

OPEC, which controls approximately 40% of world production, triggered the sharp fall in prices last November when members were unable to reach agreement on cutting production. Between November and its low in January, Brent crude fell more than 40% reflecting seemingly unfettered supply and the expectation of continued tepid growth in developed economies and a flat-lining Chinese economy.

OPEC’s decision and the U.S. shale boom are widely viewed as the two main drivers of the oil price decline. Tight oil is now a key factor of global supply growth. Since 2009, U.S. field production of oil has increased from 5.5 MMbbl/d to over 9.4 MMbbl/d by the end of 2014. Indeed, the uplift in U.S. total oil bbl/d exceeded that of the rest of the oil-producing nations combined. The U.S. is now the worldwide leader in gas production and is expected to become the largest oil producer in 2015—if indeed it is not already.

In the short term, the market has been acutely focused on the U.S. inventory build-up; however, the bigger story is the decline in the rig count and the likely decline in the rate of change in production that should become evident in the second half of 2015. According to the oil field services company, Baker Hughes, which began keeping records in 1991, the U.S. rig count (which includes both oil and gas rigs) has more than halved in the year to mid-June 2015 as the total has fallen from1858 to 857.6 The U.S. Energy Information Administration has reported a 1% fall in May monthly oil production and forecast a five-month low for July 2015.

The oil price has rallied in recent months and this has not only led some to question its sustainability, but also the validity of the industry’s response with the dramatic curtailment of projects—both planned and existing. Anadarko reported a 33% reduction in 2015 budgets, and others such as ConocoPhillips and EOG Resources have said that spending cuts were deep enough to restrain domestic output.

The drop in output could yet prove short-lived as a number of companies are now indicating that they will put rigs back to work in U.S. fields. EOG Resources, the biggest shale producer in the U.S., more recently announced that it is prepared to resume strong double digit oil growth in 2016 if the price stabilizes above $65/bbl. There are varying forecasts with, for example, Citigroup estimating that as much as 40% of the current investment cycle—about $1.4 trillion—may have gone into or will go into projects that struggle to generate acceptable returns at oil prices below $75/bbl in a survey of 37 large oil companies.

Elsewhere, it has been estimated that it would take a $40/bbl Brent crude benchmark price to materially choke-off investment and reduce U.S. production over the longer-term. Despite widespread fears, the average breakeven cost for U.S. hydraulic shale is $65/bbl, according to a recent Morgan Stanley study.

Possible Post-recovery Boom

The breakeven price varies and drops as technology advances. For the U.S. shale producers, the price is dependent on regional geological conditions, technology employed and cost of capital. On the good news front, supply-side deflation is now starting to emerge. Significant cutbacks in spending have enhanced operational efficiency. Many companies are likely to emerge from the downturn with a stronger more resilient balance sheet.

Oil prices may yet remain low, but a discerning specialist with well-developed skills and established competencies in underwriting E&P companies will focus on more than the price of oil. When underwriting an E&P client, a specialist will evaluate regional geological conditions, technologies employed, a producer’s cost of capital, the quality of the reserve base, and the economics around bringing those reserves to market. This allows the insightful underwriter to develop a surety program with a security package (indemnity/collateral) that equitably balances a client’s needs with their own.

Michael Toppi is chief surety underwriter of Aspen U.S. Insurance. This blogpost originally appeared on Aspen’s website.