The Saudis Declare War On OPEC
As we wrote in the Sachem Rock commentary a “Gusher of Hyperbole” dated October 17, 2014 we expressed skepticism that OPEC, led by Saudi Arabia as the world’s biggest exporter would decide to maintain production at existing levels (30 million barrels per day), if a reduction in production was necessary to support Brent crude oil prices in the $85 to $100 per barrel range. Our formerly expressed skepticism that prices will remain this low in the long-term persists. We do, however, acknowledge many factors are at work here, and it remains uncertain when those factors will change to support an increase in prices for the commodity.
OPEC’s official statement released subsequent to the November 27th meeting in Vienna, cited concerns about sluggish worldwide economic growth, and the importance of oil price stability over the long term. While sluggish demand growth has certainly been a factor behind the recent decline in the price of oil, we believe OPEC’s action to keep production at the existing 30 million target is to invoke a long overdue, and necessary, production discipline in its fellow cartel members.
A cartel, is not a cartel, if it does not act “as one” to manipulate aggregate production (supply) to control price. For decades, each time there was over-supply in the marketplace, the Saudis have effectively been the only country in the cartel to substantially reduce production. All the other cartel members, save perhaps, the Emirates, Kuwait, and Qatar, have cheated their individual production targets to reap the benefit from the supply cuts made solely by the Saudis for nearly twenty years.
We all learned in microeconomics, economic entities will make decisions that lead to the maximization of profit. Brent crude has descended from its recent peak of $115.71 in the middle of June 2014 to a low of $69.70, or a decline of over 46%.
All for, at most, a 1.5 million overhang in supply, or 4.9% of total OPEC production?
No, we think not.
The economic pain that maintaining production at the 30 million b/d target will impose on many OPEC cartel members that have small or nonexistent currency reserves will be excruciating. Several, including Angola, Nigeria, Venezuela, Iran, Iraq, and Libya exist almost “hand to mouth”. Eventually, as the Saudis know, all OPEC members will capitulate to the economics of the matter. This existing oversupply does not make rational long-term sense for any participant in the international oil market. OPEC members could even be joined by Russia, or other non-OPEC producers in cutting production.
The biggest threat facing OPEC is not only the increase in US shale production (supply), which increased at about 1.4 million barrels in 2014, it is also the sluggish worldwide economic growth persisting since the Financial Crisis of 2008 that has restrained demand growth for oil. In the short-term, the Saudi action to maintain the existing level of production will provide the entire world with a “giant tax cut” or “economic stimulus” in the form of lower energy prices. This will help jump start the world economy and stoke faster growth in oil demand. If Saudi Arabia can jump-start the world economy while instilling production discipline in all members of the cartel everyone wins in the long term, even the US shale oil industry. So much for the ninety pound weaklings, namely the US Federal Reserve and the European Central Bank.
The Saudis realize the long-term market for future Middle Eastern oil production is not the United States. That horse has already left the barn. It is Asia (India), the Pacific Rim (especially China and Japan), and Europe. Sachem Rock believes it will be unlikely that OPEC can sustain extremely low prices long enough to stunt the development of US shale oil in the long-term.
Oil producers such as Saudi Arabia and the US shale industry also have an interest in thwarting competition from substitute energy sources used to produce electricity to power transportation vehicles (think Tesla and UPS delivery trucks) such as natural gas, solar, and wind. So letting the price of oil settle somewhat lower, also thwarts competition from “substitute” energy sources.
The relative price stability of crude oil (i.e. – or the absence of extreme price volatility), even at lower relative oil prices, is critical to the sustained long-term capital investment essential to the further development of industry knowledge and knowhow to continue to lower the costs of oil production over time. The statement in the OPEC press release alluded to this truth specifically, and recognizes the damage to the industry that can be done during prolonged periods of extremely low pricing. This scenario would only benefit higher cost alternative energy sources that are working to reduce their costs of producing energy.
The financial media has finally started to discover that US shale producers have marginal costs of far less than $60 to $70 per barrel, especially given the increased productivity of shale oil wells with enhanced production techniques developed and applied in just the last eighteen or so months. We alluded to this before anyone in the financial media, in our October 17th commentary. Sorry about the sarcasm, but we are pleased someone finally decided to analyze a financial statement of one of the more efficient US shale oil producers.
The most efficient US shale producers, even in the Bakken, have reduced per barrel marginal well costs to at least the $40 to $50 a barrel range (accounting basis). This marginal cost does not include the most recent productivity enhancements (a minimum of 20% to 30% increase in well productivity) of US shale oil wells, so the real future marginal cost is even lower. Those well versed in microeconomics know that oil exploration companies will produce until marginal revenues equal marginal costs. Not on an accounting basis, but on a cash basis. This is profit maximization. Cash flow, and more specifically EBITDA, is what drives exploration and production companies’ stock price. Cash is needed to service debt. And everyone should remember that in 2009, shale production in the Bakken increased significantly when “netbacks” per barrel to Bakken focused exploration and production firms were in the mid $45 dollar a barrel range.
As crude oil price declines, the marginal cost of producing horizontal, fraced shale oil wells will also decline further, as oilfield services firms slash prices to keep rigs, completion equipment, crews, and materials generating revenue. The pipeline companies will also feel pressure, where competitive pipeline markets exist. It is never good to be at the bottom of the food chain in a market under duress.
We do not believe that the oil industry will take that long to react to lower prices. Shale oil production has steeper decline curves than conventional onshore vertical or offshore production. Flat or decreasing year-to-year capital expenditures will produce a short term effect on aggregate overall supply growth as shale oil well production declines significantly during the initial six months of production. The US oil producers are also at the time of year where they announce capital expenditure budgets for drilling new wells in 2015. Decreases in capital expenditures from the less efficient shale producers could turn the market sentiment in the short term. Ditto for shutting in existing production by the integrated major oil companies. As we approach the summer high season for crude oil demand the market should experience some firming in crude oil pricing as we do every year.
On Friday of last week, in response to OPEC statement regarding production, oil industry equities sustained deep declines in price of 10 to 25% as the price for WTIC (“West Texas Intermediate”) and Brent crude declined over 10 and 3% on highly negative sentiment, respectively.
Sachem Rock believes that signs of “capitulation” were evident in Friday’s abbreviated holiday trading session. Capitulation is characterized by extremely high volume and sharp equity price declines, and is indicative of irrational, or panic selling. Capitulation usually signals a market bottom; and according to the theory, equity prices will reverse and bounce off lows in subsequent sessions when market “rationality” is restored.
Oil equities continued their capitulation again Monday morning, December 1st, and oil equities advanced until the close. This morning, December 2nd, oil equities were mixed, but many smaller companies have continued to decline. We cannot confirm a bottom yet. Technical indicators signal that oil price could go lower, as this morning’s (December 2nd) price is below support in the high 60’s. The next level of support is about $60 a barrel.
For long-term investors this significant price decrease we continue to perceive as short-term, presents an uncommon long-term investment opportunity in the larger well-capitalized independent US shale oil producers, and the larger Canadian oil sands companies with more efficient operations. Balance sheet strength for naked long investments in companies with these characteristics is the overriding consideration. They must have the financial staying power to survive a prolonged period of lower prices. For those investors even more risk adverse, stick to the best of the major integrated oil companies.
As always, we recommend that all long positions be supported by married puts as we have continued to emphasize in all of our commentary, most recently in the commentary posted on November 11th, “Is It Safe?”. The world has become just too unpredictable a place not to be aggressively hedged.