Adjusting benchmarks for crude, propane prices

Over the last few Trader’s Corners, we established some benchmarks for crude and propane. The benchmarks for propane were 50 cents per gallon, 50 percent of crude at Mont Belvieu LST. We also established the $40-per-barrel benchmark for West Texas Intermediate (WTI) crude.

The purpose of these short-term benchmarks is to guide our price analysis. We look for fundamental, economic and geopolitical reasons we should change them. If we fail to find any reasons why they should change, we try to identify the causes when prices venture outside of the benchmarks.

As fate would have it, we saw prices move outside of the benchmarks for both crude and propane in the weeks after we shared our current short-term benchmarks with readers. This gave us an excellent opportunity to show our evaluation process. In each case, we believed the move from the benchmarks were short term in nature, so each time we reaffirmed the benchmarks: 50 cents per gallon LST, $40 WTI crude and propane valued at 50 percent of WTI crude. And in each case, the market moved back to the benchmark after the event.

However, we are now considering changing our benchmark on crude based on comments from a major oil producer in shale formations. Harold Hamm of Continental Resources believes that U.S. drilling will not resume until WTI crude reaches $50 to $60 per barrel. If that is the case, our $40 benchmark for WTI may be too low.

We established the $40 benchmark because we believe it to be the break-even point for much of the shale production in the U.S. The members of OPEC+, which include OPEC countries plus other producing nations cooperating with them, do not want crude’s price to rise to the point that would cause more U.S. drilling until they have fully restored their shut production. They just increased their production by 2 million barrels per day (bpd) in order to start August with 7.7 million bpd and get back to their benchmark production rates.

The WTI benchmark had held up well, averaging $39.76 since the first of June. The low price caused a major drop in U.S. drilling. After a precipitous fall, crude drilling activity has stabilized but not recovered.

So far, so good for OPEC+. At around $40 WTI, U.S. production is holding about 2 million bpd below its peak of 13.1 million bpd, and drilling activity remains subdued, with nearly 600 fewer rigs active now than at the beginning of the year. But it is in OPEC+’s best interest to push the edge of the envelope as far as it can on price without triggering more U.S. drilling. Hamm’s comment suggests there is room to push the price higher.

With WTI currently around $41.50, one might quickly conclude that if Hamm is right, another $8 could be added to WTI with major implications on drilling. But we must consider a couple of things before jumping to that conclusion. First, that kind of price increase might not increase drilling, but it would likely bring on all of the current production that is shut.

The second reason is the focus of this Trader’s Corner. While crude is valued at $41.50 for the headline front-month September contract, it is not where the market is pricing crude further out.

In our daily reports, we provide an out month price table. Its primary purpose is to let propane buyers see roughly what they would strike on price for financial hedging tools such as swaps and options for future months. There are sections for both Mont Belvieu LST and Conway, but we want to focus on the right column for WTI crude in today’s discussion.

Note that the market has established that the price of crude should be higher in the further-out months. This could be in anticipation of demand improving, as COVID-19 has less impact on crude demand. It is in these future months that a crude producer will be looking to see if they can cost-justify a well. Let’s say it is going to take a year from the time drilling starts until production begins on a well drilled in a shale formation. A producer would not be interested in the current price of crude; instead, the focus would be for around September of next year. The market price for crude in that month is currently around $44.15.

If that price would allow a production company to make money, it could hedge or sell the future production. The price of crude gets even higher further out, so it could probably lock in hedges that would guarantee a price of $44.15 or higher for its crude for as long as it wanted to have that hedge in place. Of course, if the market price of crude turns out to be higher in those months, it loses the opportunity to make more money, but in this environment, knowing profit and avoiding loss is critical. Right now, drillers may even struggle to get financing to drill a well without having a hedge in place.

Using Hamm’s assessment, it would appear crude could move up another $6 before producers might resume drilling activity. However, we are not comfortable moving our benchmark up by anywhere near that amount. Other producers could view what price they would resume drilling differently. And again, it’s not just new drilling that OPEC is trying to avoid right now; it still wants some of those once-producing wells to remain shut.

We are inclined to move our benchmark WTI price target up to $42 per barrel from the current $40 based on Hamm’s view. We are also inclined to keep our front-month propane price at 50 cents until we see just a bit more improvement in propane fundamentals. That would make propane trade at a little less than 50 percent of WTI. We will leave the 50-cent-per-gallon benchmark for Mont Belvieu LST propane at 50 and change the relative value to crude to 49 percent.

We will be monitoring the price of crude to see if its average is increasing and if that triggers an increase in drilling activity. If drilling activity does not increase, we may increase the benchmark a little more. If drilling picks up, we may leave the WTI benchmark at $42 – or even lower it back to the $40 mark.

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