A New Paradigm for Oil
OPEC’s decision on Thanksgiving not to curtail oil production caused a big hit to oil prices and stock prices across the energy sector. As of Tuesday, West Texas Intermediate (WTI) crude, a U.S. benchmark, had fallen 37%, to $68 a barrel from $107 on June 20. In reaction, the Alerian MLP Index, a performance measure of energy master limited partnerships, fell over 10% on Friday and Monday before bouncing back on Tuesday and Wednesday.
OPEC’s inaction has instituted a new paradigm for oil. We do not expect to see a big bounce in oil in the short-to-medium term. Growing U.S. shale production, higher oil output from Libya and Iran, and apathetic global demand have left the world with an oversupplied market going in to 2015. With OPEC not willing to balance the market, it falls on the shoulders of the free market to fix the imbalance. This “fix” will likely lead both U.S. and global oil producers to cut their capital expenditures. In fact, we expect companies could curtail their capital expenditures by 15%-25% in 2015. Most of the pain will be borne by producers outside of core basins and in places where the cost of producing oil exceeds $80 a barrel.
We expect oil will remain volatile in the days to come. Markets should take a while (we estimate 6-18 months) to feel the effects of capital expenditure cuts as companies will not suddenly shut off oil producing wells. Important to note, oil futures have moved into “contango” (where the forward price of oil is higher than the current price), so while the front end of the futures curve has fallen $40, the back end of the curve is down $10 to $15. OPEC’s decision was really driven by the Saudis, with support from Kuwait and United Arab Emirates. The lack of a production cut could be disastrous for OPEC countries like Venezuela and Nigeria, which rely on oil for most of their revenue. It is unclear how long those countries and Russia can survive if the price of oil stays as low as it is.
We believe oil will rebound by 2016 and 2017. We do not believe the current price is sustainable given expected demand growth and the relative dearth of spare capacity. The potential for further upheaval in the Mideast and elsewhere is much greater at these lower oil prices (we note the upcoming Nigerian elections in February and Libya’s dual governments). Even the Saudis are said to need $100 oil to fully balance their country’s budget and cover all the additional defense and social spending put in place at the time of the Arab Spring.
While the recent sell-off has been a short-term negative for energy stocks and master limited partnerships (MLPs), we believe the sector still offers good value. In our view, the best thing to do is be patient and ride out the storm.