Oil prices are sliding once more and at $57 are now some $10 per barrel below late May highs. We warned (see Agenda, Shares, 21 May) that a period of volatility was likely as rig counts in the US began to bottom out and the meeting of producers’ cartel OPEC on 4 June loomed into view.

The intervening period saw OPEC maintain its production quotas, the Greek crisis reach a new pitch of intensity, China’s stock market go into meltdown and a deal (14 Jul) with Iran over its nuclear programme promises a flood of exports from the oil-rich country.

These factors mean investors need to keep an eye on the possible downside for crude - and look for companies which have low operating costs. A potential candidate is Savannah Petroleum (SAVP:AIM) which recently (8 Jul) announced a reduced break-even price of $43 per barrel for its projected development in the Niger desert.

The market certainly looks to be over-supplied at present. Deutsche Bank sees a risk that - should OPEC production stay at its second quarter average of 31.5 million barrels of oil per day (bopd) and assuming no immediate incremental production from Iran - the global oil market is oversupplied to the tune of 1.6 million bopd in the second half of 2015.

Finding a floor

What is the floor for oil prices? Marginal costs refer to the expense of retrieving oil once the holes have been drilled and infrastructure is in place. In the Middle East this number could be as low as $10 per barrel.

We do not think prices will reach these levels. Research from industry consultant Wood Mackenzie in January this year looked at 2,222 oil producing fields, which account for total liquids production of 75 million bopd. It concluded a Brent price of $40 per barrel or below would see producers cutting production to the extent that it would cause a significant reduction in global supply.

It suggests US onshore ultra-low production volume ‘stripper wells’ - producing minimal amounts of crude with the aid of the iconic nodding donkeys - would be first to be cut. These wells - averaging output of around two or three barrels a day - produced 730,000 barrels of oil per day (bopd) in 2012 (the most recent year for which figures are available). As such they can account for as much as 11% of total US output.

Wood Mackenzie corporate research analyst Robert Plummer says: ‘The point at which producing oil fields become cash negative is key in assessing how far the oil price could fall. Once the oil price reaches these levels, producers have a sometimes complex decision to continue producing, losing money on every barrel produced, or to halt production, which will reduce supply.’

Iranian production is unlikely to be a factor in the oil market for some time. The agreement with Iran may eventually see its production return to pre-sanction levels - an increase of around 1 million bopd from the current 2.8 million bopd - but EU and US sanctions are unlikely to be lifted until 2016. Even then Wood Mackenzie estimates it could take until the end of 2017 for an uplift of 600,000 bopd to be achieved.

Key Statistics

The US Energy Information Administration has published its Monthly Drilling Productivity report for July and estimates that US oil production from the key shale regions will fall just over 90,000 bopd in August versus July, based upon its analysis of the active rig count, drilling productivity per rig and core production decline rates. Stockbroker Westhouse comments: ‘This highlights that, despite improvements in efficiency and productivity, the sharp initial decline rates that shale wells suffer combined with the dramatic fall in drilling activity will lead to a reversal in US production.’

Putting forward a bullish case for oil the stockbroker adds: ‘We believe that we have seen the lows for oil prices and that the recent decline in the oil price has been driven more by concerns about an overheated Chinese stock market, the Greek crisis and the prospect of a surge in Iranian exports. We do not believe any of these factors are likely to have a significant impact on the global supply/demand picture in the near term and would stay focused on fundamental data, which is beginning to look more supportive for oil prices, we would suggest.’

Despite Westhouse’s optimism it would be prudent for investors in the oil and gas sector not to expect too much help from a recovering oil price in the short-term and therefore to be very selective when approaching the sector.

Low-cost operator:

Savannah Petroleum (SAVP:AIM) 42.4p

The company is focused on the exploration of the R1/R2 and, subject to award, R3/R4 blocks in the Agadem Rift basin in ‘benign desert conditions’ in south east Niger.

The acquisition - funded by a $36 million fundraise (9 Jul) - of R3/R4 will leave the £50 million cap in control of around 50% of the Agadem basin - with Chinese state operator CNPC holding the remainder. It sews up the remaining unlicensed acreage making a planned farm-out deal more straightforward. Independent auditor CGG Robertson has doubled its estimated resource for R1/R2 alone to 1.2 billion barrels and estimates a break-even oil price for the project of $43 per barrel based on an outline development plan (based on CNPC’s existing hub strategy) from the company.

The technical risk (i.e. the risk of not finding oil) looks limited. CNPC has drilled 93 discoveries from 124 exploration wells (an impressive strike rate of 75%). The cost of these onshore wells is relatively low but a 30 well programme could cost around $150 million and it needs a partner with deeper pockets to fund this activity.

Taking a view on the stock essentially means deciding whether the company will be able to secure a farm-out. The market for these kind of deals may be somewhat depressed but chief executive Andrew Knott tells Shares if he had any doubts over the company’s ability to deliver on this front he would have raised substantially more than the $36 million the company banked from the recent placing. Backing up Knott’s assertion that he could have raised more, some notable institutions participated in the issue including existing shareholder Standard Life Investments.

The company also needs an export route for its crude given the modest size of the domestic market. CNPC is currently working on a 700 kilometre section to tie-in to the existing Chad-Cameroon pipeline and Knott says he expects this to come on stream in 2017. Mirabaud has a ‘buy’ recommendation and 125p price target, implying 194% upside.