Investors and oilfield service and equipment firms are always looking for clues as to where activity is headed. At this point, the most valuable information is what operators’ E&P spending plans are for 2018. However, oil and gas companies are still in the middle of building their capex budgets for next year; few final decisions have been made and even fewer announcements about those decisions are public.
In the meantime, we can guess at how these budgets are forming, from the forecasting method they use. Even if this method is flawed...
It comes as no surprise that the budgeting process inside an oil company begins with a forecast of oil and gas prices. Over many years we have found that it is common for operators to take the 12-month trailing average oil price, discount it by 15% and use that as their forecast for oil prices for the coming year. At least this method has the benefit of simplicity!
The other option for many firms is to take the futures strip as their oil price forecast. This creates a couple of issues, one of which is “the futures strip as of what date?” The mid-September strip when the 12/18 oil price was $47 or the mid-November strip when the 12/18 price was $53? This is especially critical for firms working in non-Permian plays where breakeven prices are higher and ROIs are lower.
The other issue with using the futures price strip is that it has a lousy track record as a forecasting tool. Going back to 2000 we’ve looked at the one-year futures price at the start of each month and then compared it to the actual spot price for that forecasted month. Turns out there is only a .07 correlation between the expected change in oil prices and the actual change in oil prices, as shown by the chart.
Correlation between Spot Price Actual Change and 1-Year Futures Price Expected Change Lagged One Year
The basic problem is that 70% of the time the futures market forecasts that the price of oil will change 10% or less (up or down) over the coming year, when in reality the price of oil changes more than 20% (up or down) more than 70% over the coming year.
This tells us that the futures strip should be regarded as a hedging tool rather than as a price discovery mechanism.
For the record, we think operators as a group will end up using an oil price of $45-$50 in establishing their 2018 drilling plans; this would be little changed from their year-ago level, meaning similar capex budget planning. We don’t see operators adopting oil prices above $55 for their budgeting process until after 2018.