The Organization of the Petroleum Exporting Countries (OPEC) meeting ended on 11/27/14, Thanksgiving Day, with the decision to leave their production quota unchanged and no clarity on when a cut might be forthcoming. The lack of any quota cut, combined with little indication that OPEC were particularly focused in the short term on quota compliance, caught the market by surprise. Crude oil prices and energy equities fell sharply.
We have reflected on the meeting outcome and its implications.
Are OPEC dysfunctional or is Al Naimi of Saudi just being savvy?
We think probably the latter, and reiterate two important criteria for Saudi:
- Saudi is interested in the average price of oil that they get; they have a longer investment horizon than most other market participants
- Saudi wants to maintain a balance between global oil supply and demand to maintain a price that is acceptable to both producers and consumers
On further analysis, Saudi’s decision to not shoulder an OPEC production cut is consistent with both of the above objectives.
We were not particularly surprised at the ‘no cut’ decision from OPEC, but we had not expected the lack of clarity in their accompanying comments nor the size of the market reaction.
The average price of Brent in 2014 will be around $100, even if it averages $70 for the rest of the year. If it stays at $70 until April, then averages $90 until December 2015 and then $105 in 2016 and 2017, the average for 2015-17 would be just under $98 per barrel – a reduction that they would hardly notice. We believe that Saudi went to the meeting perfectly willing to cut production to put a floor under the price but were unwilling to take the responsibility alone. While Kuwait and the United Arab Emirates (UAE) would have likely supported such a move, in our opinion, agreement from other members of OPEC about the size of the cut and who within OPEC should shoulder the burden was clearly not forthcoming. With Libya suffering civil unrest, Iranian production depressed by sanctions and Iraq still recuperating, there was clearly not enough cohesion among the other countries to generate a consensus. Saudi still no doubt has a vivid memory of the 1982-1985 period when it was the only OPEC member pulling its weight and took production down to 3 million barrels per day when its capacity was around 10 million barrels per day. In the face of improving non-OPEC supply this time, Saudi clearly does not want to play the role of the lone ‘central banker’ again.
So $78/bbl Brent, as it was at the time of the meeting, was not enough to galvanize the group to make a unanimous decision about production. Crude oil fell by nearly $10 per barrel in the subsequent days; maybe that is enough to see a change of opinion? It is certainly a level which should remind high spending US shale oil companies (as well as some of their more errant OPEC colleagues and Russia) of the need for more capital discipline. If oil prices do not find a floor in relatively short order, we would expect to see an unscheduled OPEC meeting called with an emergency quota reduction and an actual physical reduction in oil supply thereafter.
In terms of informational content, we noted that there was no mention this time of OPEC supporting $100 oil as a sensible oil price for both producers and consumers. This does not change our long-held $100 per barrel long term oil price view (it is driven by economic analysis rather than OPEC commentary), nor our belief that OPEC favor $100 long term.
That said, we sense that Saudi & co. are eyeing US shale oil production growth and would prefer a shallower oil price recovery for the time being, rather than a ‘V’ shaped recovery, i.e. one that doesn’t allow US oil growth to accelerate unabated. If we are right, it is logical for Saudi to tolerate a lower oil price for months rather than weeks.
Analyzing the decision of OPEC not to cut production quotas, it may well be that they are more comfortable with current supply/demand dynamics than many commentators are. Even on current estimates (pre-this period of lower oil prices), the International Energy Agency (IEA) expected second half 2015 supply/demand to be broadly in balance after a period of oversupply in Q1 2015. Real time indicators, such as Asian refining margins and Middle East to Asia tanker rates, are moving in line with season norms and broadly in line with historic ranges – there is no data indicating particular demand weakness in the oil market currently. This does not appear to be a re-run of 2008/09.
So, in all likelihood, Saudi (together with Kuwait and the UAE who are working well together) will probably keep production unchanged (and hence prices in the $60-80 range) until they see signs of capital discipline, particularly in the US. Note their aggregate production is around 15.5 million(m) barrels(b)/day, which is 2.65 million b/day above the level of 12.85 million b/day at the end of 2010. Because many Exploration & Production (E&P) companies have a fair amount of forward oil production hedged, we would expect this stance from OPEC to last for six months or so. Only then, once discipline has been reinstated, will they likely cut production to bring the price back up. North American E&P companies, ironically, should be very grateful to them – some pain now could lead to gain in later periods as investors find their worst fears of a collapse in the oil price much reduced.
What happens to oil supply in a lower price environment?
While oil demand looks fine, and will likely be buoyed by lower prices, we note that the global oil balance has loosened in recent months due to accelerating non-OPEC supply. A key question now is the reaction of non-OPEC supply to those lower prices, should they persist.
With US shale oil, we are in new territory. What we do know is that North American E&P companies live hand to mouth, converting one year’s cash-flows into next year’s capital spending. In 2014, capital expenditure (capex) is likely to be 15% higher than initially expected as a result of oil prices being higher than expected over the year (West Texas Instrument (WTI) likely to average $95 per barrel). Our estimate of US onshore production growth in 2014, accordingly, has gone from 0.8m b/day to 1.2 m b/day. So; 15% more capex brought 400,000 barrels per day of extra peak production. This is the marginal near term investment of the global oil and gas industry and is sufficiently ‘short cycle’ in its nature that we should see a capital spending reaction come through pretty quickly.
Assessing the speed of US oil supply response is difficult, but we thought we would highlight sensitivity analysis carried out very recently by Tudor Pickering Holt which shows:
- A flat $80 WTI oil price from here would drive a drilling rig reduction of about 200 rigs and slow growth in US oil production to 0.7m b/day in 2015 and 0.4m b/day in 2016 (vs 1.2m b/day in 2014)
- A flat $70 WTI oil price from here would drive a drilling rig reduction of over 500 rigs and slow growth in US oil production to 0.6m b/day in 2015 and to nearly zero in 2016 (vs 1.2m b/day in 2014)
So far, we have witnessed capex budgets for 2015 that are down around 15% from Continental Resources, 25% from Apache and 50% from Denbury Resources. Moreover, Apache is expecting to cut its rig count by around 50% in 2015. These are pretty dramatic cuts, and we expect to see a lot more announcements of similar size over the next 2-3 months.
We see Russian oil production already starting to roll over, even before lower prices have had a chance to bite. The Russian situation is worsened by sanctions; we are told, for example, that it is currently close to impossible to raise financing for new seismic activity. Lukoil have already announced a 13% cut to 2015 capex. A combination of the effect of sanctions and a lower oil price could easily result in Russian production down by 0.5m b/day over the next 12 months.
Elsewhere, Brazil is likely to be a brighter spot for production, but the rest of non-OPEC will likely start to struggle further. Recall that in the aftermath of 2008/09 downturn, even though the fall in the oil price was brief, non-OPEC supply outside North America had shifted into decline by 2011.
What does this add up to for oil and equities?
We expect oil to trade in a $60-80 range in the near term. This is an unsupported level which may fluctuate significantly. If this price range persists, we expect North American unconventional supply growth to slow rapidly. And we expect OPEC to announce production cuts by late summer 2015 at the latest, if the physical market is not rebalancing quickly enough. This points to a possible rise in oil prices in the second half of 2015.
Longer term we think oil would likely recover to $100/barrel(bbl), possibly by the end of 2016, then we predict that it would inflate with the world economy, growing at 3% in real terms.
Clearly one’s view of energy equity valuations is dictated by future oil price assumptions. Energy equities have traded off sharply in sympathy with the recent fall in the oil price, such that they appear to discount a long-term crude price of around $70/bbl.
If oil eventually settles back at around the $100 level, we now see a potential upside in the sector of around 50%.
Portfolio Manager, Guinness Atkinson Global Energy Fund
Opinions expressed are subject to change, are not guaranteed and should not be considered investment advice.
Mutual fund investing involves risk and loss of principal is possible. The Fund invests in foreign securities which will involve greater volatility, political, economic and currency risks and differences in accounting methods. The Fund is non-diversified meaning it concentrates its assets in fewer individual holdings than a diversified fund. Therefore, the Fund is more exposed to individual stock volatility than a diversified fund. The Fund also invests in smaller companies, which involve additional risks such as limited liquidity and greater volatility. The Fund’s focus on the energy sector to the exclusion of other sectors exposes the Fund to greater market risk and potential monetary losses than if the Fund’s assets were diversified among various sectors. The decline in the prices of energy (oil, gas, electricity) or alternative energy supplies would likely have a negative effect on the fund’s holdings.
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Global Energy Fund HOLDINGS (as of 10/31/2014)
1. BP PLC 3.69% 2. Suncor Energy Inc. 3.66% 3. Chesapeake Energy Corp. 3.57% 4. Total SA 3.56%
5. PetroChina Co. Ltd. 3.55% 6. Royal Dutch Shell PLC 3.54% 7. Helix Energy Solutions Group Inc. 3.53% 8. Gazprom OAO 3.53% 9. Exxon Mobil Corp. 3.52% 10. ShawCor Ltd. 3.50%
Fund holdings and/or sector allocations are subject to change and are not buy/sell recommendations.
Capex is the capital expenditure, or the funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment in order to maintain or increase the scope of their operations.
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