On November 27, Saudi Arabia and its 11 partners in the Organization of the Petroleum Exporting Countries (OPEC) failed to agree on production cuts, causing a steep drop in oil prices to their lowest levels in five years.
As SA contributor Michael Fitzsimmons correctly pointed out, the reason for maintaining the 30 million barrels a day of oil output is that Saudi Arabia wants to defend its market share and learn the threshold of pain of U.S. shale producers. In his article, which I suggest everyone must read, Fitzsimmons explains how Saudi Arabia could sacrifice roughly $138 million of oil revenues a day to learn the breaking point of U.S. shale producers. That said, the Saudis "might be surprised at how long it takes" to find this out.
I, however, believe that there won't be any surprises here for Saudi Arabia. The Kingdom understands the realities of the market, and knows exactly what must be done.
Accepting the new kid
By maintaining its existing levels of production, Saudi Arabia, as well as OPEC nations, have also acknowledged the reality of the market, the emergence of the U.S. as the world's biggest oil producer.
According to EIA's estimates, U.S. production has climbed significantly over the last six years amid a shale-powered boom, from just 8.47 million barrels a day in 2007 to 12.36 million barrels a day in 2013, showing 46% growth. In the same period, Saudi oil output went up by just 13% to 11.6 million barrels a day in 2013.
By keeping its current levels of production, Saudi Arabia is also telling the world that the responsibility of putting brakes on sliding oil prices must be shared by both, the U.S. and Saudi Arabia. This is in contrast of the long-established, and perhaps obsolete, view that only Saudi Arabia, or the larger OPEC for that matter, is in a position to command meaningful influence on crude prices.
America's move
Consequently, the U.S. shale producers will likely respond by adjusting their budgets and production growth. In other words, the oil producers will likely reduce their capital expenditure and exploration and production activity. The slowdown is already evident in the declining rig count since October 10, as reported by Baker Hughes (BHI), as well as a 37% drop in the number of drilling permits approved in November, as compared to October.
However, so far, only a handful of companies, including Royal Dutch Shell (RDS.A), ConocoPhillips (COP), Continental Resources (CLR), Halcon Resources (HK), Denbury Resources (DNR) and Rosetta Resources (ROSE), have planned to lower their capital budgets or drilling activity in 2015. I believe others, who were perhaps waiting for OPEC's decision, will likely announce capital expenditure cuts through the first quarter of 2015.
06/05/2015
Eventually, by the beginning of the second quarter of 2015, when a majority of oil producers would have announced their capital expenditure plans, Saudi Arabia would have learned the pain threshold of U.S. producers.
On the flip side, by that time, the U.S. producers would have learned that they will have to play an important role of sharing the responsibility to balance the oil market with OPEC nations.
In this context, the date of OPEC's next meeting on June 5, 2015 is particularly relevant. The oil cartel will have ample time to make its production-related decision by thoroughly studying the demand-supply fundamentals. Goldman Sachs predicted in a recent report that OPEC might announce production cuts in that meeting.
The price of benchmark American crude would eventually average around $70-$75 a barrel in 2015, Goldman Sachs estimates. By comparison, WTI oil futures were largely above $90 a barrel throughout the first three quarters of this year.
How to play the downturn
For investors, this will be an opportunity to separate the high-quality names that can grow production in spite of lower crude prices, such as EOG Resources (EOG) and Devon Energy (DVN), from the mediocre ones that struggle with high costs, such as Denbury Resources.
Elsewhere in the energy space, refiners such as Valero (VLO) Marathon, Petroleum (MPC), and Phillips 66 (PSX) are set to be one of the biggest beneficiaries of lower crude prices.
Further, pipeline MLPs will continue growing their distributions - the U.S. oil production could slow down, but won't come to a halt. Further, some of these pipeline MLPs, such as Plains All American (PAA), generate the majority of their cash flows from fee-based businesses, which minimizes their exposure to the volatile commodity price environment.
(I consider the general partner Plains GP Holdings (PAGP) a better investment than the MLP, though.)
Bottom Line
The U.S. oil producers and OPEC are going to balance the oil market together, just as Saudi Arabia wants. For U.S. oil producers, this would require adjustments in capital expenditures and production growth.