2018 Energy Insurance Market Conditions

Energy Prices

West Texas Intermediate (WTI) monthly average crude oil spot prices have remained over $60 per a barrel in the first half of 2018, with prices reaching a relative low of $45.18 per a barrel in June 2017 and steadily increasing in the last 12 months. ¹ The US Energy Information Agency (EIA) attributed recent price growth primarily to declining petroleum inventories following production cut agreements among the Organization of Petroleum Exporting Counties (OPEC) and other oil producing countries executed in January 2018. Combined production in OPEC countries subject to the reduction agreements fell to a 3-year low in April 2018. ² Additionally, continuing political instability in Venezuela and the consequential impact on the oil industry and potential US sanctions of Iran have led to decreased production expectations in the two countries. ³

Following a meeting of major oil producers, including OPEC, on June 22, 2018, the participants endorsed a plan to increase nominal output by 1 million barrels a day. However, the impact of the resolution on the market remains to be seen. ⁴

Regarding natural gas, Henry Hub spot prices have gradually increased to a monthly average of $2.97 per million British thermal units (MMBtu) in June 2018 after reaching a relative peak of $3.69/MMBtu and a trough of $2.67/MMBtu in February 2018 and January 2018, respectively. ⁵ Natural gas prices are forecast to rise steadily over the next several years. In its weekly natural gas update on June 27, 2018, the EIA noted that natural gas supply and consumption had grown significantly from the first half of 2017 through the first half of 2018. ⁶ Consumption and total supply grew 11 percent and 10 percent, respectively, over the same period. The stronger demand is being driven by expanding residential and consumer heating needs, the buildout of natural gas-fired power plants, and an increase in exports over year-ago levels. ⁷

The charts below illustrate the WTI and Henry Hub historical trends and forecasts.

Debt and Capital Expenditures

Large-scale development projects are one of the key drivers of demand for insurance coverage in the oil and gas industry. Directionally, these outlays tend to move with oil prices as companies delay or cancel projects during sustained declines. Having taken on heavy debt loads in the preceding boom, companies had been forced to maintain high production levels from existing wells at lower prices to sustain cash flows.

As the market has recovered and quarterly operating cash flows bounce back from 2015/2016 lows, companies have primarily allocated excess capital toward paying down debt. Accordingly, while experiencing a modest uptick, capital expenditures have not increased in line with operating cash flows as more favorable market conditions have returned. The EIA has observed that sustained levels of higher pricing, coupled with deleveraging, may ultimately contribute to increased capital expenditures. ⁸

Looking forward, the short-term outlook has shifted toward cautious optimism. Cost-cutting and operational efficiency initiatives undertaken in the midst of the downturn have lowered wellhead breakeven prices in almost all major US basins, and rig counts have increased over 50 percent since 2016. ⁹ US upstream capital spending is anticipated to increase 9 percent in 2018, building on the recovery experienced in 2017. ¹⁰

Impact on the Insurance Industry

Although energy prices and domestic production have continued to recover, premium income challenges remain for upstream insurers. While exploration and production activity is anticipated to expand in 2018, pressures including merger and acquisition activity among upstream industry participants, increasing use of captive insurance companies, heightened competition with regional competitors, and insurer consolidation are likely to limit premium income gains. ¹¹

Insurance Overcapacity

Additionally, overcapacity remains a persistent problem for upstream insurers in 2018. With two new entrants and only one withdrawal, PartnerRe, in the energy insurance space within the last year, theoretical capacity has reached a new high despite lack of growth in premium income.

Excess capacity has led to intense competition among underwriters that will limit upside potential as upstream activity resurgence. ¹² Under this imbalance, premiums will continue to come under pressure, resulting in a soft market.

Interest Rates Rise

Citing improving labor market conditions and inflation expectation, the Federal Open Market Committee has twice raised the target federal funds rate in the first half of 2018 from 1.5 percent to 2 percent. Materials released in June 2018 indicate targets through 2020 approaching prerecession levels but remaining below historic lows. ¹³

Increases in interest rates are a positive for insurers. Insurers benefit by investing the proceeds from premiums in financial instruments, which generate returns often rising or falling in line with the federal funds rate. Accordingly, holding losses constant, the industry stands to benefit from the shifting interest rate environment.

Conclusion

Following the recovery in oil prices in the last few years, there are now signs of improvement as industry players look to put money back to work in new exploration activities while reducing reliance on short-term cost-cutting measures. However, persistent overcapacity driven by clean loss records and low yields in the broader marketplace continue to moderate any recovery that could be realized from increased demand. The energy insurance industry will continue to face challenges as excess capacity persists and premium income stagnates but will benefit marginally from higher returns on investments.