After seeing a stellar ending last week, oil prices retreated somewhat, led by Brent, after news broke that Saudi Arabia, Venezuela, Qatar, and non-OPEC member Russia have agreed to explore an oil production freeze in an effort to prop up energy prices, and after news broke that Iran is resistant to the idea until it grabs back its market share or unless it is given "special" conditions, whatever that means. Certainly, a freeze on output is a step in the right direction at a time when OPEC has been largely responsible for the worsening of this glut (though the U.S. moved the world in that direction) but I do not believe that this will hold. Rather, I believe this is the first step in a multi-month process that will lead to a cut in output for the group, a move that will be bullish for crude in the long run.
What the picture looks like with a freeze
According to reports coming out of Doha, Qatar, the location of this meeting, the group has agreed to push forward a plan to cap production at what was experienced in January of this year. Based on data from Russia, this implies output moving forward of 10.88 million barrels per day, while OPEC's production should come out to 32.63 million barrels per day. Collectively, this means that output moving forward should be capped at approximately 43.51 million barrels per day, representing 45.6% of global oil output if we use OPEC's production forecasts for the rest of the world. In the table below, you can see what the picture should look like if this forecast holds true and if the other members of OPEC agree on the plan (Iraq has already indicated willingness to go along with any plan).
Using what is presented in this table, it appears as though growing global demand (though at a small rate of 1.25 million barrels per day year over year) for oil, combined with lower forecasted oil output from non-OPEC nations outside of Russia will result in a gradual narrowing of the supply/demand imbalance in the market throughout this year. During the first quarter, OPEC believes the imbalance will result in excess production of 2.18 million barrels per day during the first quarter this year. This will fall to just 0.08 million barrels per day during the third quarter before popping slightly higher in the fourth quarter to 0.48 million barrels per day. Collectively, OPEC believes that oil production will outpace demand by 1.20 million barrels per day this year.
Of course, Iran may make this difficult. After seeing sanctions released earlier this year, the country has pledged to increase production by 0.50 million barrels per day almost immediately, followed by an extra 0.50 million barrels per day six months in. Personally, I'd be surprised if they can manage such an increase in production in such a short period of time but, if they are correct, the country's average output will rise by about 0.75 million barrels per day this year. This is reflected in the table below, which shows that supply will outpace demand during 2016 by 1.95 million barrels per day.
OPEC should cut
This data certainly looks bearish for crude and, if it comes to fruition, will be hard on prices. Having said this, I don't believe OPEC will continue this strategy moving forward. Rather, I see this as a first step toward decreased output from the group, plus Russia, in the months to come. The rationale behind this is fairly straightforward. For starters, as some other authors have suggested, the amount that oil has to go for needs to be far higher than it is today for these nations to avoid shrinking GDP.
Although Saudi Arabia and some other OPEC members can survive for years under these circumstances, dwindling reserves will impair value for them in the long run. Meanwhile, other nations like Venezuela and Nigeria will certainly see a massive economic contraction if the market doesn't turn around soon. In essence, if OPEC continues this pricing war, everybody will end up a casualty and the payoff could be small for the group of nations. Let's assume the following scenario applies:
OPEC decides to maintain its freeze approach and Iran manages to increase its output to pre-sanction levels. During this timeframe, oil prices average $30 per barrel. Once the glut starts to shrink, we will have prices at $40 per barrel and once the glut starts to shrink by 0.50 million barrels per day, oil prices grow to $50 per barrel. Once the glut shrinks by 0.75 million barrels per day, prices rise to $70 per barrel. I'm also using the assumption that non-OPEC production shrinks by 1.50 million barrels per day starting in 2017 and by just 0.50 million barrels per day in 2018 and that OPEC's core assumptions for 2016 are correct. Under all of this, the current oil glut is assumed to be about 600 million barrels right now.
In the table above, you can see what the overall trend should look like, both in terms of the global oil supply/demand imbalance and in terms of how much money, in millions, OPEC and Russia will bring in each day if they sell oil at said prices (excluding the extra money brought in by Iran). Collectively, over the next three years, the group could be expected to bring in sales of $2.76 trillion. If, however, they were to cut production by 5% while allowing Iran to increase its own output accordingly and if the market recognizes this all as a very bullish move, sending prices up higher today, you can see the results in the following table.
Based on this analysis, the amount of money OPEC and Russia will generate (again, excluding the increase in Iranian output) would come out to $3.09 trillion. This assumes, very generously, that oil demand continues to grow at a slow pace of 1.25 million barrels per day each year (it's likely to be greater absent a major economic downturn) and that the world adds on output equal to 50% of OPEC's cut in 2016, followed by an increase in output that would match OPEC's and Russia's cut in both 2017 and 2018. Personally, I'd find this surprising unless oil prices move above $70 or $80 per barrel, given the high cost of much new oil output in recent years, but I like using conservative numbers in my computations.
In the event that OPEC and Russia can get Iran to cut (something I believe is likely but not on the same terms that the rest of OPEC and Russia will see) and if oil production in the U.S. grows at a slower pace than I indicated, the financial performance of the group is likely to be even more impressive over the next few years. Now, some of you might say that oil production in the U.S. and elsewhere will soar, and there is truth to that if oil prices rise too high, but do keep in mind that the breakeven cost of oil in places like the U.S. really aren't as low as some in the media have led you to believe.
In the graph above, you can get a glimpse of the "cash costs" of producing oil depending on the source of production. In the short term, companies can generate a great deal of cash flow because the cash costs of output are low but this graph does not factor in non-cash items that will eventually put a drain on the companies in question. Although this does not apply with every company, many operators in this space report depreciation, depletion, and amortization costs of between $20 and $25 per barrel. This also does not factor in maintenance capex (geared toward keeping production unchanged), which can vary from company to company. In the case of Breitburn Energy Partners (NASDAQ:BBEP), for instance, I calculated that number at $9.43 per barrel. For non-shale operators, the price is likely lower. Nor does any of this factor in capital expenditures dedicated toward growth, which can vary meaningfully.
What we see here is that, for at least some portion of oil production, the portions that are the most likely to see an uptick in output thanks to the advent of fracking, the breakeven cost of output is likely $25 to $40 per barrel higher than that graph shows. This suggests that categories that require $20 on a breakeven basis are likely to need prices of $45 to $60 in the long run to continue to operate. To incentivize the lending activity that is required in order to increase production further, we are probably looking at prices of at least $10 per barrel above this range at a minimum, so $55 to $70 per barrel, before any real uptick in production takes place. For OPEC and Russia, this likely creates a more favorable scenario that will generate even more revenue for them than my model forecasts.
Right now, Mr. Market seems to be afraid that OPEC and Russia will not cut. Truth be told, I do not know if Iran will end up cutting and, if not, whether the group will swallow a larger share of the cut themselves, but these issues appear to be more political than they are logical. Logically, OPEC doesn't just want to cut; it needs to cut if it wants its economies to come out of this looking good. Yes, it does mean admitting defeat in the price war and it may or may not force them to give Iran a better financial standing in the world, but it will also mean that every member of OPEC and that Russia ultimately end up better off.
The alternative is to keep on track, trashing their respective economies, and end up with greater market share but at a lower price point that ultimately means less revenue for them down the road. This could be the path that OPEC and Russia decide to take, but it's certainly the least logical. Ultimately, higher prices are needed for their economies to survive and that higher price will, eventually, lead to U.S. output rising but output in any given country can only rise by so much before the cost of increasing output further becomes too great. If this means OPEC and Russia need to keep cutting until the U.S. hits this point, so be it, after which they will be able to enjoy strong price increases with no fear of additional compensation. Any other path is the definition of masochism.
Disclosure: I am/we are long BBEP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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