Investor appetite for oil has yet to be tested fully

The battle for supremacy in world oil markets can be seen as a contest between different economic models: between governments and markets. So far, the market-based system has held up better than many observers expected when crude prices started falling. But the test is not over yet.

In Opec member countries, oil output is determined by the government. In the US and other developed economies, government control over oil production is minimal, limited to indirect influence through taxation, regulation and drilling rights.

What regulates oil output in developed economies is principally access to capital. The US exploration and production companies that led the shale revolution have mostly run cash deficits. Even before the oil price crash, they needed continual inflows of capital and their needs are greater now.

In spite of the plunge in benchmark US crude from over $107 per barrel last June to about $49 today, the capital markets are still supporting the shale industry.

But a few smaller companies have been unable to carry the weight of their debts. Quicksilver Resources, a Texas-based gas company, entered Chapter 11 bankruptcy protection last month.

Samson Resources, an oil and gas producer backed by private equity group KKR, said in its annual 10-K filing last week that it was evaluating its options for restructuring its debts, and warned that it might have to follow Quicksilver into bankruptcy.

So far, however, those stories remain exceptions rather than the rule.

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Bank lending for US exploration and production companies is usually secured against their oil and gas reserves. The value of those assets is recalculated at regular intervals, typically twice a year in the spring and autumn, so many companies are finding that their borrowing bases are shrinking.

Even so, US exploration and production companies borrowed $18.2bn in syndicated loans in the three months to March: the most for a first quarter since 2008.

There are also private equity groups that have raised tens of billions of dollars to invest in oil and gas, representing a significant additional source of capital.

However, Tamar Essner, an energy analyst in Nasdaq's investor relations consultancy business, says she noticed a difference in attitude between generalist and specialist energy investors at the Scotia Howard Weill energy investor conference in New Orleans last month.

The generalists were more optimistic about the outlook for oil, Ms Essner said, in part because they were comparing the sector with the wider market.

The S&P exploration and production sector index, which includes many of the principal US shale producers such as ConocoPhillips, EOG Resources, Anadarko Petroleum and Devon Energy, has dropped 36 per cent from its peak last June.

Compared with a rise of about 5 per cent in the overall S&P 500 over the same period, that makes oil company shares look attractive.

Specialist investors, however, were more cautious about the outlook, because they were less confident of a rebound in oil prices, Ms Essner added.

Oil companies' share prices seem to be influenced more by the positive views. The equity valuations of the larger independent oil companies imply a long-term US benchmark crude price of $87 per barrel according to RBC, and about $85 according to Barclays. That is about 75 per cent higher than the short-term price in the futures market, and more than 30 per cent higher than the price for December 2020 of about $65 per barrel.

Analysts at Barclays argue that the gap between the futures market prices and equity investors' expectations must narrow over time, and say they see "significant downside" in exploration and production company share prices.

Meanwhile, low interest rates are both holding down the cost of borrowing for companies and helping potential investors such as private equity.

These favourable financial conditions do not seem to be in any imminent danger of coming to an end. The signs last Friday of a slowdown in US employment growth suggest interest rates could stay lower for longer than had recently been believed.

Still, if rates start rising and stocks falling while crude prices remain weak, it could cause investors to reassess the attractiveness of US oil and gas.

The market system has shown it can do a good job of supporting shale oil investment and production at a time of easy money. Its performance in more challenging financial conditions has not yet been put to the test.

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