OPEC+: Changing Course or Prudent Tweaking?
- In our view, an increase in targeted OPEC+ production to be announced next month would represent a rational tweaking of supply amid continued dwindling global oil inventories and potential further geopolitical disruptions.
- We expect oil inventories to remain tight, and likely to continue to draw in 2H18, even assuming some increase in OPEC+ production.
- Limited spare OPEC capacity, constraints to US shale growth, and large downside to Venezuelan output are key factors that could lead to much higher near-term crude prices.
- We view demand destruction as a legitimate risk, but more likely at significantly higher oil prices.
- We continue to see meaningful upside to select equities in the sector, as we do not believe most stocks have been pricing in a $70+ long term WTI oil price.
Most energy pundits are keenly aware of oil’s boom-bust price history, which has been frequently driven in large part by OPEC policy. As such, it wasn’t surprising when many of them asserted that last week’s indication of easing production cuts by Saudi Arabia and Russia signaled the end of crude’s recent ascent, and possibly the beginning of a meaningful price drop. Conversely, we view the possibility of higher near-term OPEC production as a rational tweaking of supply in reaction to a rapidly tightening global oil market and the likelihood for further geopolitical-related production declines.
The recent suggestion of increased production from the two largest oil producers in the newly-formed OPEC+ group comes ahead of the cartel’s next formal meeting on June 22 in Vienna. It is also a logical response to a dramatic falloff in oil production from key OPEC producer Venezuela and an expected drop in Iranian production with the resumption of US sanctions. Furthermore, despite a delayed impact, the 1.8 million barrels/day (mmbpd) of OPEC+ production cuts that went into effect on Jan 1, 2017 has been successful in accomplishing the objective of reducing OECD inventories back to the five-year average, a key factor to oil’s recent price surge.
Sources close to conversations have relayed that near-term OPEC+ production could be boosted by 300-800 thousand barrels/day (mbpd), with Saudi Arabia siding toward the lower figure and Russia at the higher end. These increases could be made with immediate effect and could slow the pace and extent of rising crude prices. Maybe most threatening, the likely formal announcement of higher targeted production at the Vienna meeting next month could undercut the positive investor sentiment that has finally benefited the energy sector in recent months. Nevertheless, even with the new concern of OPEC+ changing course, we offer the following constructive points on crude fundamentals and the outlook for energy equities:
- Near-term inventory tightness unlikely to subside. Perhaps unnoticed by many investors is that not only have global crude inventories been massively reduced over the past year, but that inventories even drew during 1Q18, a period when supply normally builds. We attribute much of this to a continued robust demand environment from both developed and emerging markets, highlighted by refinery runs that have defied their typical maintenance season. The result is global crude supply now at relatively depleted levels at the start of the higher-demand summer driving season.
Additionally, it seems all but certain that the chaos in Venezuela is likely to lead to a further substantial decline in its oil output, particularly with the threat of additional US sanctions after last week’s widely-criticized “rigged” presidential election. As such, in the near term, we would not be surprised to see Venezuelan production fall below 1.0 mmbpd from its latest report of 1.4 mmbpd and a high of 2.4 mmbpd at the end of 2016. We note some reports are even citing the potential for an absolute collapse in Venezuelan exports. Separately, it now seems likely that many European buyers and service suppliers to Iranian oil will comply with US sanctions, increasing the likelihood of production in that country falling by an estimated 300-500 mbpd. With these factors in mind, the math rather clearly suggests that the additional OPEC+ production should only soften the impact of ongoing supply disruptions, rather than leading to a significant reversal in global inventories.
- Limited spare capacity. We think energy investors frequently overestimate the amount of spare capacity that could enter the market in the short and intermediate term. While the 1.8 mmbpd of OPEC+ production cuts indicate a similar, if not larger, amount that could quickly be added to global supply, it is important to note that production was ramped going into the cuts. Analogous to eating a box of doughnuts before going on a diet, both Saudi and Russia were producing at record levels in 2H16 just prior to the cuts. (See table chart below.) Moreover, estimated Saudi full production of 11.5 mmbpd, versus 10.0 mmbpd currently and a high of 10.7 mmbpd in July 2016, remains largely theoretical and subject to downward revision given the maturity of many of their key oilfields. Finally, even assuming significant spare capacity with Saudi oilfields, we question the Kingdom’s ability to quickly open the spigots to fill the supply gap given their own drawn-down inventory levels (largely the result of backwardation in the forward curve) and any potential longer-term reservoir damage that has resulted from the recent production cuts. As such, the record level, pre-cut 2H16 OPEC+ production levels may more closely resemble full capacity than many analysts appreciate.
According to DOE estimates, OPEC’s spare capacity is currently less than 2.5% of global oil demand, a figure we believe could fall below 2% or well lower by year-end given the above-mentioned geopolitical factors and barring any major fallout in near-term demand. For reference, a drop in spare capacity to roughly 1% in 2008 was accompanied by a Brent oil price of roughly $140/barrel. As such, it is not difficult to envision crude prices at substantially higher levels based simply on a spare capacity argument.
A key difference today from prior spikes in oil prices is the existence of rapidly-growing US shale production and, in turn, growing US exports. Still, given the infrastructure constraints in the Permian Basin (highlighted by a dramatic widening in the Midland-Cushing price differential), along with other ground-level constraints that we have often discussed, the US has limited ability to fill the forecasted supply gap under current demand in our view. This is combined with a dearth of new large projects from other non-OPEC countries on docket for 2019 and 2020 that relate to project cancellations during the latest downturn. The result is an increased call on the spare capacity held by OPEC+ countries. Hence, we view a formal announcement next month to raise OPEC+ production as a prudent reaction to meet that call in a gradual, well-telegraphed manner.
- Saudi and Russia still very motivated toward high oil prices. It was only slightly over a month ago that media sources reported that senior Saudi officials in closed door briefings were targeting a $80-$100/barrel range for Brent crude prices. (Saudi, as well as OPEC in general, has no official oil price target.) This robust target range is being financially-driven due to the Kingdom’s still significant dependence on oil-related revenues, where last fall the IMF estimated that Saudi needs roughly a $70/barrel Brent crude price to finance its economy. (To further illustrate, at the end of 3Q17, Saudi’s cash reserves in three years had fallen by $261B to $458B due to the decline in oil prices.) The new Crown Prince Mohammed bin Salman is unquestionably determined to diversify the Saudi economy through his Vision 2030 initiative. Still, in the intermediate-term, Saudi’s dependency on oil revenues is unlikely to diminish, particularly given its rising military spending and large social programs that have been necessitated by a youth unemployment rate over 30%. Finally, despite being delayed, the IPO of state-owned Saudi Aramco remains in the plans for the Kingdom and remains another motivator for robust oil prices.
For Russia, its financial motivation for higher crude prices is similar to that of Saudi, especially given the impact of a falling ruble in recent years. Additionally, Russia’s cooperation with Saudi, while surprising to many, is likely underpinned by political motives related to its desire to play a more significant role in the Middle East.
- Demand destruction at high oil prices and a strong USD is a legitimate risk, but more likely at considerably higher prices. The variable we are watching most closely is the demand response of higher oil prices, particularly for economies that have also seen their currency recently depreciate significantly versus the USD. We believe this was a key factor to oil’s large 2014 price decline, albeit from much higher levels than today and after a greater change in USD currency rates. We also note a price elasticity analysis performed by Energy Aspects that contends that for each sustained 25% increase in the Brent oil price above $80/barrel, demand growth slows by 40%. The analysis also concludes that economic shocks, not price shocks, lead to absolute declines in global oil demand, like 2008/2009.
Similarly, we would contend that the end of energy cycles tends to be driven by fallouts in demand, rather than supply factors. Under the concept of price discovery, crude prices should trend to the level that brings demand growth in line with supply. Still, we believe it is important to acknowledge the tight road OPEC+ will need to navigate going forward. As mentioned above, both Saudi and Russia are highly incentivized for robust crude prices. Still, neither country would like to see prices spike to levels that would result in widespread demand destruction, a scenario made plausible with current geopolitics and limited spare capacity. Again, we would view some planned increase in OPEC+ production as a prudent means to filling the call for such barrels and seeking to maintain a robust, but not demand-destructive, oil price.
- We don’t believe equities have been pricing in a $70+ long-term WTI oil price. Given that much of the value of oil producers lies in the resources they possess in the ground, we believe it is appropriate to assess the valuations of such companies by discounting the potential free cash flows of these depleting assets under various long-term commodity price scenarios. Based on our analysis, even after a recent broad equity price appreciation, most oil weighted E&Ps continue to price in a long-term oil price well below current prices. This may largely relate to lower prices in future years on the forwards price curve (i.e., backwardation) and Midland-Cushing differentials that have blown out significantly with an apparent shortage of takeaway capacity in the Permian Basin. To those factors, we would point to the upward movement in the entire oil price curve in recent months, rather than simply increased backwardation, and that the Permian takeaway shortage is a near-term condition estimated to be solved by new infrastructure in 2H 2019. Finally, with the fundamentals supporting a $70+ WTI crude price still firmly in place in the short/intermediate term, as well as a $60+ price longer term, we continue to see meaningful upside to select equity prices in the sector.
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