Oil Prices Viewed Through Three Lenses, Each Providing More Insight

Oil Prices Viewed Through Three Lenses, Each Providing More Insight

September 01, 2020

Outside the Dow Jones Industrial Average and the S&P 500 indices, the price of oil runs a close second in terms of market interest. More importantly, the price of oil is the single largest value driver for exploration and production (E&P) companies, mineral owners, oilfield service companies, and numerous other industry participants.

With this in mind, it benefits decision makers to view oil prices through multiple "lenses."

First Lens – Current and Historical Pricing

Although a good start, understanding the current price of oil is only one useful data point available to analyze and ultimately act upon.

Oil prices have been quite volatile since 2005, rising to almost $150 per barrel and recently trading as low $16 per barrel, before recovering over the last several months to their current $43 per barrel pricing.

Historical and current commodity prices provide a general market sense of context which can aid investment decisions. However, future sales, distributions, dividends, and/or royalties are driven by future oil prices, regardless of historical levels.

Second Lens – Futures or "Strip" Pricing

Given the volatile nature of spot prices, there are now active futures markets for commodities. In simple terms, this allows investors to trade variably-priced commodities for an agreed-upon fixed, future price. Many oil companies will use futures to hedge a portion of their future production against future price moves; those with debt are often required to hedge against future price volatility by their lenders.

^CL NYMEX Strip Futures Prices

crude oil chart decreasing then stabilizing 

In liquid markets such as the NYMEX exchange for crude oil futures contracts, most consider the markets to be "efficient." Market efficiency refers to the degree that market prices reflect all available, relevant information. If markets are efficient, the efficient market hypothesis assumes all information is already incorporated into prices. At the beginning of the year, oil prices were trading above $60 per barrel, but markets were in backwardation with future spot prices expected to decline. Today, the strip prices reflect a general recovery from $43 to $48 per barrel over the next three years.

Again, making any investment decision based on commodity prices requires a thorough consideration of expected future pricing, regardless of historical and spot price behavior to date. As shown, current oil prices and expectations of future oil prices can change dramatically in a matter of months.

Third Lens – Probability-Enhanced Futures Pricing

Most disciplined oil and gas investment decisions are based on valuations using futures commodity pricing inputs. However, the single reported value, or clearing price, for an oil futures contract is surrounded by many other observations and investment positions that reflect higher or lower prices. The larger the spread around the clearing price, the larger the uncertainty as measured by the volatility.

While no one can determine future prices with certainty, with some straightforward statistical analysis, options traded on futures contracts do provide insight as to what market participants expect. The NYMEX WTI Crude Oil futures (CL) is the world’s most liquid crude oil contract. WTI refers to West Texas Intermediate, a U.S. light sweet crude oil blend. Given these markets, we can examine where futures prices are today to predict where spot prices will be in a few weeks or months. This process is useful for estimating the future price range for oil.

Remember the normal curve from your first statistics class? We can use it to determine the probability that future prices will be within a certain range. In a normal distribution, there’s about a 68% chance that a data point lies within one standard deviation of the mean, and about a 95% chance that it lies within two standard deviations.

Analysts and traders use metrics known as option Greeks to decode the sensitivities of futures and options to price changes. Using option Greeks, we can determine the prices and probabilities that market participants as a whole are expecting. How can we determine the likely behavior of such a large and often unpredictable group? Because investors are already telling us what they expect by voting with their dollars, not just their intuition.

Take a look at the price distribution below, which shows the crude oil spot price on August 28, 2020, and predicted crude oil prices based on option and futures markets. The blue lines are within one standard deviation (σ) of the mean and the orange lines are within two standard deviations of the strip prices.

WTI Crude Oil $ /BBL

crude oil chart 

Based on the August 28, 2020 prices, the markets indicate that there is about a 68% chance that oil prices will be between $38.00 and $48.00 per barrel in mid-October. Likewise, there is about a 95% chance that prices will be between $28.00 and $57.50.

By mid-February 2021, expectations are that the +/- 1σ price range is $34.00 to $56.50 per barrel. In other words, the markets indicate there is about an 84% probability that the price of oil will be at least $34.00 per barrel.

Key Takeaways

The "third lens" provides investors and analysts with additional tools with which to measure value. For instance, if drilling a group of wells did not make sense at a spot price of $43.00 per barrel, one might decide that it had no value. However, if there were a 60% chance that prices will be above $50 per barrel in one year, this additional information would support the attribution of “option value” to the project.