OPEC’s Freeze Backfires

The oil supply “freeze” is a joke. That much was confirmed Tuesday in comments made separately by the oil ministers of Saudi Arabia and Iran. The latter called it “ridiculous,” no less.

The punchline? The joke’s on OPEC.

There are several glaring problems inherent to the freeze, whereby members of OPEC and other large producers such as Russia are supposed to not raise their oil output from current levels, not least that they are already producing too much oil for the market to absorb.

But there is a more subtle effect that actually works against the likes of Saudi Arabia: The freeze raises hope. In particular, it raises hope in the otherwise largely despondent world of energy financing.

Monday night, before those oil ministers iced the freeze, Cabot Oil & Gas, a U.S. exploration and production company, announced it had sold an upsized offering of new shares that should ultimately raise roughly $1 billion.

Now, Cabot is overwhelmingly a natural gas producer, so you might be wondering what this has to do with the oil freeze.

Well, Cabot’s stock actually tracks oil futures a bit more closely than it does gas futures: Its correlation coefficient with oil over the past year is 0.45 versus 0.31 for gas, according to data compiled by Bloomberg.

In this, Cabot isn’t alone: Even pipeline companies, supposedly insulated from oil-price swings, have seen their correlation with crude spike. Part of the reason for that is higher leverage, putting the fate of companies more in the hands of the oil market, leading their stocks to trade accordingly.

Cabot’s ratio of net debt to equity was already north of 100 percent at the end of 2015 — hence the desirability of raising cash by selling new shares equivalent to more than 11 percent of those outstanding already.

But you might also think, given the current environment, that it would be hard to sell those shares at a decent price. I certainly thought so when I wrote this piece in early January about Pioneer Natural Resources raising $1.6 billion with an equity offering. My thesis was that, unlike the flurry of offerings that characterized early 2015, only those E&P companies with the strongest of balance sheets already, such as Pioneer, would be given the time of day when tapping investors for more cash.

Well, it turns out I was wrong about that.

Apart from Cabot and Pioneer, seven other U.S. E&P share sales have been priced so far this year, raising $6.4 billion altogether.

If sellers keep up that pace, nearly $11 billion of equity could be raised by the sector this quarter, surpassing the record set in the first quarter of 2015. Sure, the roster of offerings so far in 2016 features companies that are more like Pioneer — notably Diamondback Energy, possibly the most assiduous company in the sector when it comes to tapping the market (it has done four offerings since the start of 2015, Bloomberg data show).

But it also includes companies with less-pristine balance sheets such as Cabot, Oasis Petroleum and Devon Energy. It isn’t like underwriters seem to be demanding bigger risk margins, either:

Coming so soon after the fourth quarter of 2015, one of the slowest for E&P equity deals in the past decade, the appetite for new paper by definition reflects hopes that the worst is over. One remarkable fact about the offerings so far this year is that, as of Monday’s close, all had risen since pricing despite their dilutive effect on the shares outstanding — a peculiar and recurring theme in the sector during the past year that I have written about previously. In a report e-mailed on Tuesday, Tudor, Pickering, Holt declared that the “flood gates are open.”

Such hopes certainly don’t rest on the current state of the global oil market, with supply still outpacing demand and refiners showing signs of fatigue.

Rather, they spring from vague expectations that countries such as Saudi Arabia and Russia may freeze production, with Iran possibly deciding to join them, or that this could be a prelude to outright production cuts.

Such notions are encouraged by cryptic asides from various energy officials. And yes, it must be great to move markets and add an extra few millions to your country’s rapidly emptying coffers by throwing a bone to the press and the markets.

But the price for doing so is alleviating the gloom hanging over U.S. E&P companies, giving them access to the vital resource they need to stave off steeper production cuts: capital.

Saudi oil minister Ali Al-Naimi said on Tuesday that his country has “not declared war on shale,” and he can be taken at his word. The shale industry is not easy to go to war with over oil prices. Its short investment cycle means it could likely come back reasonably quickly once prices rose again, capping any gain — as both OPEC’s secretary-general and the International Energy Agency noted on Monday. More vulnerable are oil projects requiring long lead times and big upfront spending, such as those in Venezuela (as an aside, this was the only OPEC country cited by Mr. Al-Naimi in his opening remarks on Tuesday as having pumped “previously uneconomic” oil during the boom).

Yet even if he isn’t a warmonger, the natural corollary of the Saudi Arabian minister’s policy is that it will keep prices low until some rivals have to withdraw. As he put it himself:

Efficient markets will determine where on the cost curve the marginal barrel resides. The producers of those high-cost barrels must find a way to lower their costs, borrow cash or liquidate.

Talk of freezing merely delays that process. Maybe that’s why he went on to trash it a few minutes later.

bloomberg