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.