For Oil Prices, We Are in the Middle of a Perfect Storm

 | Jan 25, 2018 | 10:00 AM EST
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The massive breakout in energy commodities has taken another leg up early on Wednesday, with West Texas Intermediate crude quoted at $66.09. Sixty-six dollar crude! Who would have imagined that figure was possible in the dark days of yore, when crude settled at $42.74? That was only seven months ago, by the way; WTI closed at $42.74 on June 22, 2017.

Well, I imagined it, and I felt like Chicken Little with my "oil is going to $60" call in early December, when the front month crude contract dropped below $56/barrel. I knew we would get to $60/bbl, but even I am surprised to see crude trading at $66 today.

We are in the midst of the perfect storm for oil prices: U.S. inventories have declined for 10 weeks in a row, U.S. consumption is growing at a rate that I have never seen -- motor gasoline product supplied rose 8.1% in this week's EIA data -- OPEC is holding on to production quotas and finally, the U.S. dollar is sinking like a stone.

Treasury secretary Steve Mnuchin has been jawboning the greenback down this week, and, as crude is quoted around the world in dollars, a lower dollar will tend to support oil prices.

Other carbon-based fuel pricing benchmarks are showing strong gains, as well. Brent crude futures were trading at $70.82/barrel early on Thursday morning and, almost in the blink of any eye, U.S. natural gas futures have shot up to $3.54//mmBTU.

I have noted countless times in my Real Money column that the natgas futures contract is un-affectionately known as the widow-maker among energy traders, and when it moves to the green, short positions can be obliterated very quickly.

But what about the stocks? Well, I can't think of a more constructive environment for oil producers than the current one. These companies are making huge incremental margins on their unhedged volumes, and if they so choose, they can hedge future production at much higher rates than would have been available for an out-period hedge a year ago.

Yes, the oil futures curve is heavily backwardated now -- future months' prices are lower than current -- but to a producer, that doesn't really matter. What matters is the absolute price that can be locked in.

A simple example can be shown by looking at the current front-month contract, which settles in March 2018. If we join Sherman and Mr. Peabody in the Way-back Machine, we can see that on Jan. 25, 2017, that contract was trading at about $55.55/bbl.

In today's market, the March 2019 contract is quoted at $60.55/bbl. So, if you are a hedging producer, you made $5 bucks per barrel in the past year -- about 9% -- by doing nothing. Unhedged producers have obviously made much more, but really, the key is that 9%-plus drops straight to the bottom line of E&Ps.

So, back to the stocks, the key ETF for oil producers, Energy Select Sector SPDR ETF (XLE) , has done well in recent markets, posting a 19.6% gain in the past six months and an 8.2% gain in the past month. It has been a good time to be long a basket of exploration and production names, but what frustrates me to no end is the variance in performance among the individual stocks.

For instance, in that same six-month period, Denbury Resources (DNR) shares have soared 94.6%, while shares of Evolution Petroleum (EPM) have fallen 4.4%. That may seem strange on the surface, but it becomes unfathomable when one realizes that Evolution has only one asset, the Delhi Field in Louisiana. Delhi is operated by, yes, you guessed it, Denbury Resources.

The performance of individual E&Ps makes no sense to me, but ultimately higher commodity prices equal higher cash flow. The heavily-shorted names in the group -- like my top pick for 2018, Sanchez Energy (SN) -- are going to feel a lift when these shorts realize that higher oil prices are here to stay, and higher cash flows from those higher prices mean these small companies are not only solvent, but will be generating copious amounts of free cash flow as 2018 progresses.

So, if you are long small-cap E&Ps, be patient and realize basic economics are on your side. If you are short them, well, you are just plain wrong.

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