The chief operating officer at Continental Resources (CLR +0.00%) said that oil producers would be forced to cut back on production if the United States doesn't allow for crude oil exports.
Will oil production see a sunset? An oil in West Texas. Source: Wikimedia Commons.
Is a problem of plenty brewing?
Speaking at the IHS CERAWeek, Rick Bott -- president and COO of Continental -- said that crude oil prices will remain artificially depressed because domestically produced crude isn't finding its way into the global markets. And this eventually lowers the incentive to keep up with production volumes. As evidence, he points out to the fact that the crude oil markets are heavily "backwardated."
To give readers a general idea, in a backwardated market, the futures price for a barrel of crude oil is less than its current or spot price because market participants believe that the spot price will be lower in future. Quite simply, oil producers are wary about hedging their future production for prices that are less than current prices.
To get an idea at what prices sellers may have to hedge their forecasted production today, the following chart should help. It shows how the WTI and Brent futures prices currently look:
Source: CME Group; author's graphics.
Intuitively, the first thing we can figure out from the chart is that future crude oil supply seems to be higher than perceived demand, hence the fall in prices as we go further out in time. But is it a justifiable view?
Looking at the current scenario, this does sound logical. With the advent of unconventional drilling in the form of hydraulic fracturing of shale rock -- popularly known as fracking -- the United States' energy landscape has been transformed. And accordingly, the past five years witnessed a steep rise in domestic crude oil production. Consider this: At the end of February, U.S. crude oil production stood at 8.08 million barrels per day, or bpd, a solid 50% higher than the 5.37 million bpd at the end of February 2009. With production levels forecasted to increase further, oil producers feel the need to hedge their production from price fluctuations, and more specifically, from a drop in prices.
Hedging: A part of the game
Unconventional drilling, after all, is expensive. With cost of production from the shale plays ranging between $60 and $70 a barrel, it's evident that exploration and production companies would want to hedge their future production from price volatility. For example, Continental Resources has hedged 10.8 million barrels of WTI crude and 19.1 million barrels of Brent crude for 2014. Putting these volumes into perspective, the company had totally produced 35 million barrels of crude oil in 2013.
Kodiak Oil & Gas Corp (USA) (NYSE: KOG), another Bakken operator, is expected to hedge up to 75% to 90% of its forecasted production . The company has entered into a swap agreement for 25,800 bpd at an average swap price of $93.41 for 2014. Chesapeake Energy Corporation (CHK +0.00%), on the other hand, has hedged 58% of its forecasted 2014 crude oil production.
Small cap exploration and production company Halcon Resources Corp. (HK +0.00%), for its part, has hedged approximately 70%-80% of its current and future production for the next 18 to 36 months. The Houston-based company primarily operates in the Bakken/Three Forks, the Eagle Ford, and the Utica shale plays. Another small-cap unconventional driller, Magnum Hunter Resources Corp. (NYSE: MHR), has hedged about 6,300 bpd for 2014. That's more than 80% of its production last year.
In other words, we notice that for oil producers hedging is an integral part of the game irrespective of their size.
Is the current ban worrisome?
So what happens if future prices drop below the cost of production? As you would expect, hedging then becomes unfavorable. So should investors be worried? As of now, they shouldn't. There shouldn't be such fears, since WTI futures are priced at nearly $80 per barrel for as far out as November 2019. Brent futures, on the other hand, are priced at over $92 a barrel over the same duration. Even in the backwardated situation, the lower prices quoted far into the future is greater than production costs. As of now, oil producers have little to worry about.
Final Foolish thoughts
Simply pointing toward a backwardated market is at best a weak argument for the United States to throw open its gates for crude oil exports. While crude prices could come down as domestic production increases to unprecedented levels, a cut in output shouldn't necessarily be the only outcome. If gasoline prices come down as a result of growing production, the U.S. economy, as a whole, will only receive a major shot in the arm that should drive crude oil futures higher. In essence, a growing economy is a whole better catalyst for profits and appreciation of shareholder value than to allow exports which may or may not end up enhancing a company's bottom line.
