Oil Market: State of Play

19 October 2016

Investor Education – What’s Driving the Oil Market

Oil Market: State of Play

The price of oil plummeted from over $100/barrel in 2014 as the shale gas boom disrupted the industry,
and OPEC decided compete by pumping more oil, adding to oversupply problems. Since bottoming earlier this year the oil price has recovered to $50/barrel, and we discuss the current state of play in the oil market.

Background
The price of oil started to crash in June 2014 as shown in the chart below. A number of
factors contributed to the price decline, but ultimately an oversupply problem was the
major catalyst for the selloff. The US is relying more on fracking (shale gas boom) and
OPEC has refused to cut its production. Demand simply hasn’t been able to keep pace
with the additional supply, and pure economics dictate that lower prices were needed
to find an equilibrium.
Investor panic and turmoil caused a rout across commodity stocks and resulted in one
of the worst starts to a calendar year for equity markets in 2016, and the oil price was
a major casualty. Since 2014 supply has far outweighed oil demand, although as we
pointed out earlier in the year concerns were overdone. However, since the start of
the year the outlook for oil has stabilised significantly.

WTI Crude Oil (USD/barrel):

It has taken a couple of years of low prices, but most recently there was a major change
in intention by OPEC (the Organisation of Petroleum exporting Nations) which we
discuss below. The US shale gas boom has been one of the major reasons for the
oversupply in energy markets and we have also seen forecasts for US shale (a direct
substitute for oil) signal a drop in production, somewhat remedying the global gasoline
glut.

What is OPEC
OPEC is the governing body comprised of 13 petroleum-exporting member states and
account for 40% of global oil production and 73% of the world’s “proven” oil reserves.
Evidently, OPEC is the single most influential entity on global oil prices. It begs the
question as to why OPEC did not cut its production to prop up the oil price and balance
the oversupply issues?

The reasoning largely comes down to game theory. OPEC has been trying to force high
cost oil producers and US fracking operators out of the oil market. OPEC believe if they
can keep the price of oil low enough for long enough, their competitors will go out of
business and means they can resume operating in a less competitive oil environment.

While there were signs that the strategy was working, with a pullback in US production,
Iran has come back online, and the low oil price is also having a damaging effect on
OPEC’s member states. Saudi Arabia is largest exporter of petroleum and possesses
18% of the world’s proven petroleum reserves. The oil and gas sector accounts for
about 50% of gross domestic product, and about 85% export earnings.
Saudi Arabia’s foreign cash reserves fell by US$100 billion last year and are expected
to decline even further as the country attempts to fund its budget short falls caused by
the slump in oil prices. Depressed oil prices are expected to lead to double digit budget
deficit again in 2016.

Following many failed attempts at reaching an agreement (mainly driven by the
ongoing geopolitical conflict between Saudi Arabia and Iran), the price of Crude oil
jumped on news that OPEC has agreed to cut production for the first time in eight years
at the end of September.

This is a massive change in approach by OPEC from its “pump at will” policy adopted in
2014, and as indicated above, even the strong oil producers like Saudi Arabia are
feeling the pinch and are now willing to the address the low oil price as quickly as
possible.
The deal will reverberate beyond the Organization of Petroleum Exporting Countries
(OPEC). OPEC has reportedly said that it will reduce output to 32.5 million barrels a
day, nearly 750,000 barrels a day lower from what it pumped in August. While the
decision has recently been made, it appears concessions were made by Saudi Arabia,
which has been facing continued pressure in its economy as a result of low oil prices.
OPEC is bringing barrels of production out of the market, which is a flip on its strategy
to not reduce production. While the number of actual barrels that will be taken off
the market is unclear, what’s more important is that the Saudis appear to be
returning to a period of market management.

Outlook from Here
While we do not forecast a huge rally in the oil price from current levels, there have
been a number of positive developments for the industry with expectations that
production will moderate (and could even fall), while demand remains fairly robust.

Further, the oil price is back to circa US$50 a barrel, and we believe prices will cap
out at around these levels due to the impact of US shale gas producers.

US energy exploration & production companies are willing to accelerate activity at $50-
55/barrel, and a report noted that they have raised >$30 bn in equity year to date,
almost twice the amount raised during the whole of last year. Most energy companies
are also far more efficient than they were a few years ago. Oil companies have needed
to compete through cost deflation, and several analysts expect a number of projects
will breakeven at $50/barrel. Industry profitability and activity looks to be recovering,
despite lower oil prices.

The market’s focus may currently be on OPEC’s ability to help the rebalancing, but we
believe the more important market reaction has played out – as the industry has
already adapted to low prices, and activity is coming back online.

Hence, our view continues to be for a gradual recovery in oil prices as the global energy
market supply/demand imbalance is corrected over the next few years, and oil may
trade around $50/barrel for some time to come.
Portfolio Implications
After cautiously waiting for the opportunity to take advantage of the oil sell-off we felt
that the conditions had been meet to seek out attractive investments leveraged to the
oil and gas industry earlier this year, and added an oil exposure to our portfolio in April
– Woodside Petroleum (WPL.AX). WPL remains our top pick in the Australian Energy
sector.
In our view, WPL is the best way to play a volatile oil world given implied valuation
floors in its LNG contracts, a relatively strong balance sheet and its ability to get into
assets at the bottom of the market given strong operating capability.

The price of oil plummeted from over $100/barrel in 2014 as the shale gas boom disrupted the industry, and OPEC decided compete by pumping more oil, adding to oversupply problems. Since bottoming earlier this year the oil price has recovered to $50/barrel

Do You Want Daily Market Insights?

If you’re interested in staying up-to-date with the latest news and analysis on stocks, be sure to sign up to BlackBull Research.

1 Month Free Trial

Access our expert stock market research Free of charge with no obligation

Free 1 Month Free Trial

Unlock this article & access our expert stock market research

ASX, NZX & USD Stock Buy, Hold, Sell recommendations. Model Portfolios. Daily news and more

[pmpro_checkout]