by Todd Heltman and Jeff Wyll, Senior Energy Analysts, Global Equity Research, Neuberger Berman
The oil patch has come into focus in the wake of OPEC’s extension of production cuts and the resilience of U.S. shale producers. This week’s guest writers, longtime energy analysts for our Global Equity Research team, assess recent developments and what may come next.
Back in November, OPEC managed to surprise oil skeptics by agreeing to substantial production cuts—a reduction that was complemented by additional cuts from a number of non-OPEC producers, including Russia. The subsequent rally, tied also to bullish sentiment around the Trump election victory, brought oil prices back to a more profitable mid-$50s level and seemingly on their way to $60.
The optimism, however, was relatively short-lived. After holding onto price gains for a few months, markets became more pessimistic on the significant production response from U.S. shale producers (and renewed concern about a global oil glut). A recent move by OPEC and other oil producers to extend the reduction for nine additional months was met with disappointment given hopes that the cuts would be either deepened or made permanent.
So, where do we go from here? All eyes are once again on two key movers of today’s oil market, OPEC and U.S. shale companies.
Stresses Have Driven Efficiency
To understand why, look at the origins of the recent turbulence. OPEC from 2015–2016 maintained a policy of aggressive production growth to increase its market share and reduce the competition. The net effect was record-high global inventory levels and low oil prices, which severely stressed the sector and prompted some bankruptcies among higher-cost, more leveraged producers. But low-cost North American shale companies (particularly in the Permian shale basin) turned out to be surprisingly resilient—and increasingly efficient at extracting oil and gas. This was driven both by the industry’s cyclical and structural efficiency gains and advances in technology that allowed for more production. Ultimately, low-cost shale producers survived, and the pain caused by the OPEC-driven inventory surge and resulting low oil prices contributed to its decision to cut production in November.
In addition to the efficiency gains for U.S. producers, what came next was perhaps the second unintended consequence of the OPEC cuts. Representing an effective subsidy from OPEC, the agreement served as a green light for U.S. energy producers, some of whom had already started to ramp up activity with the help of wide open capital markets (which U.S. producers had tapped to bridge funding gaps, strengthen balance sheets and ultimately restart growth plans) as well as the rebound in prices from early 2016 lows. The U.S. shale industry, now low-cost and well-capitalized, appears to be on track to grow oil production by roughly 1 million barrels per day in 4Q 2017 over the same period last year. With the backdrop of still-high inventory levels, this growth has unsettled investors and forced OPEC’s hand again last month.
Unsolved Problem
While it’s helpful to supply/demand fundamentals that OPEC is continuing its production limits, a key issue is that they are not permanent. As a result, it’s possible that up to about 1.5 million barrels per day of production could come back into the market in 2018. As of now, OPEC has not detailed a formal exit strategy for its current program. Moreover, Libya and Nigeria, which were not part of the original agreement, remain production wildcards. Couple that with the potential for an additional 1 million barrels per day of shale production, as noted above, and you have the makings of a renewed oil glut, even if the overall economic growth picture (and thus demand) remains healthy.
In an ideal world (one that many oil bulls continue to anticipate), higher-cost, more marginal production (off shore and conventional) would begin to see declines given underinvestment and project cancellations over the past three years. But again, the resiliency of the oil sector may have been underestimated, as Brazil, the North Sea, Canada and the Gulf of Mexico, to name a few examples, have been able to continue growing as long lead time projects started in the 2011–2014 boom are still hitting the market today. This growth has offset declines in more challenged parts of the world such as Mexico, Colombia and China. Additionally, the global “super majors” have improved their cost structures, cutting spending while maintaining at least flat production levels so far. That leaves it to OPEC to extend its reductions or for market pressure to come to bear once again on less cost-efficient shale producers. This is not to say that we expect a doomsday scenario by any means. Based on all of these factors, we believe a reasonable band for pricing over the intermediate term could be $40–$60 per barrel, with OPEC action likely to protect the low end and shale growth potentially capping the high end. As always with oil, unexpected shocks can send the price above or below expected ranges.
For Investors, Cost Structure and Technology Are Key
Regardless of who blinks first (OPEC deepens cut or the shale producers reduce activity), it’s important to remember that structural cost efficiency gains are a substantial offset to a decline in prices. As one oil executive has said, “Fifty dollars is the new ninety dollars.” In other words, companies are increasingly focusing on lowering their cost structures and using new technology to reduce extraction costs. So, stock picking has never been more important. The task for equity investors, in our view, is to identify energy companies with the lowest sustainable cost structures and the technology leaders who continue to drive efficiency gains. This could help them navigate difficult price environments.
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