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OPEC to the Oil Market: We Told You So

Matthew DiLallo, The Motley Fool

For months, most oil-market watchers fretted about the impact that newly imposed U.S. sanctions on Iran would have on global supplies. Those concerns pushed the price of crude up to more than $85 a barrel, while many analysts anticipated that oil could soon reclaim the triple digits as supplies tightened further. President Trump and others called on OPEC to boost production so that oil prices didn't get out of hand.

OPEC, however, refused to budge because it believed that the market was worried about the wrong thing. Instead of an undersupply issue, OPEC thought the market had more oil than it needed, so it was concerned about another glut forming that could put downward pressure on prices. That's exactly what seems to be happening after the Trump administration gave waivers to key buyers of Iranian oil, allowing it to continue supplying them with crude. That shift has quickly deflated oil prices, which has at least one OPEC nation considering a production cut.

An oil pump at twilight

Image source: Getty Images.

Drilling down into what's going on in the oil market

Oil prices had been red-hot this year. At one point, crude was up nearly 30% on the year, peaking in the mid-$80s on fears that Iranian sanctions would pull as many as 2 million barrels per day (BPD) off the oil market. That would have put an even greater strain on the market's spare capacity, which was already under pressure due to production issues in places like Libya and Venezuela, as well as pipeline problems in the U.S. and Canada that are holding back growth in both regions.

However, crude prices have since tumbled nearly 20% after the U.S. surprisingly granted waivers to both China and India, Iran's two main oil-buying customers. Because of that, the tightening of supplies that many in the market expected isn't happening.

Instead, the market is now likely to have too much oil, because the higher prices over the past year have started cooling off demand just as oil production in the U.S. has reached record levels. That's causing Saudi Arabia to consider slashing its output by as much as 500,000 BPD in the next month, according to a recent report by Reuters. That would reverse the Middle Eastern nation's previous decision to hike its production this past June to offset some of the anticipated impacts of the U.S. sanctions on Iran. Meanwhile, it's working with other producers in OPEC to cut supplies by 1 million BPD overall, which would reverse their previous production increase. The hope is that these steps will help stabilize the price of crude.

An oil rig and platform at sunset

Image source: Getty Images.

How this impacts oil stocks

The slump in crude prices over the past month has hit oil stocks hard. Leading U.S. producers Anadarko Petroleum (NYSE: APC), Occidental Petroleum (NYSE: OXY), and ConocoPhillips (NYSE: COP), for example, have all tumbled more than 15% from their recent highs.

That's because changes in oil prices have a significant impact on oil companies' cash flow. In ConocoPhillips' case, every $1-per-barrel change in the global oil benchmark price impacts its annual cash flow by about $100 million. The nearly $15-per-barrel plunge in crude prices over the past month will cause it to generate significantly less cash flow if the current level holds.

However, ConocoPhillips, like most of its peers, was never banking on $85 oil. Instead, ConocoPhillips based its 2018 spending plan on crude averaging $50 a barrel. Thanks to that decision, it has been generating significant excess cash flow, which it used to pay down its debt and repurchase stock. Anadarko Petroleum, likewise, used $50 crude as its budget benchmark for 2018; it has also been using its excess cash to buy back stock and retire debt. Meanwhile, Occidental Petroleum recently achieved its breakeven plan, allowing the company to maintain its current production rate and dividend on the cash flow it can generate on $40 oil; it will be able to grow production when crude is above $50.

Because all three set their 2018 budgets based on $50 oil, the recent plunge in crude prices is unlikely to change their 2018 spending plans. However, it could affect planning for 2019. Given the recent plunge in oil prices, oil producers might rethink big budget increases. That could cause a more moderate increase in drilling activity levels next year, which would be bad news for the oil-field services industry -- it was expecting a big year in 2019.

The oil market's wild ride continues

While all eyes had been on a tightening oil market, OPEC's biggest worry was that supplies wouldn't drop as much as feared -- which is what has happened in recent weeks. Now it's thinking about cutting supplies again to bring the market back into balance.

While that move could boost prices, it's increasingly likely that oil will remain in a period of heightened volatility as the market digests new headlines and data in the coming weeks. That uncertainty will likely continue weighing on oil stocks -- especially those of service companies -- until there's a bit more clarity about what's ahead for the oil market.

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Matthew DiLallo owns shares of ConocoPhillips. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.