Originally published on Dec. 9, 2014
On November 27th while most of us in the U.S. were gathering with our families to celebrate Thanksgiving, the twelve nation members of OPEC (Organization of the Petroleum Exporting Countries) were also gathering together for their biannual meeting to discuss global oil production and prices. The price of crude leading up to the meeting had been under pressure, falling from a July high of just over $115 per barrel to around $80 per barrel; a fall of over 30% in just four months' time. It was widely expected that the OPEC members would agree to production cuts in order to limit supplies and therefore bolster the price of crude globally. That expectation proved false as the Saudi Arabian-led group held production steady at 30 million barrels a day. As a result, oil collapsed an additional 10% on the day following the meeting. At last check Brent crude traded around $69 a barrel, more than a 40% decline from its highs earlier this year.
It appears that in order to protect their market share, Saudi Arabia has engaged in a price war against U.S. shale oil producers who have been able to increase production to 9 million barrels a day (levels not seen since the early 70's) and expect to continue to increase in coming years, eventually topping out at 11 million barrels per day. This newfound supply coupled with lower demand due to slowing economies in Europe and Asia are the root causes for the downward pressure on the price of crude oil.
Lower oil prices are extremely dangerous for most OPEC members as they are wholly dependent on their oil exports to maintain social and economic stability. Most member nations require oil prices to be above the $100 per barrel mark in order to balance their budgets. Social stability in these nations is reliant upon oil-funded spending programs that are designed to satisfy the public and keep their regimes in power. Without income from oil, social unrest is inevitable. For example: Venezuela requires oil to be priced around $120 per barrel in order to meet their self-imposed spending requirements, Iran needs an even loftier price close to $140 per barrel, and Nigeria's spending requires a price per barrel of $100.
Despite pressure from the aforementioned member nations and others, the more influential Saudi Arabia, providing one third of OPEC's production, used their clout to maintain the production levels of 30 million barrels a day. By opposing the cut they appear to be attempting to drive prices down below the level at which U.S. shale and Canadian tar sand oil production is economical. For shale oil that number is estimated to be around $60 per barrel. While the majority of the OPEC members will suffer, the Saudis will be able to weather lower prices because their coffers are full and production costs are relatively low.
Ultimately, we don't expect that this tactic will be successful. U.S. shale producers have technology and innovation on their side. They have been able to rapidly lower production costs from near $100 per barrel five years ago to below an average $60 per barrel currently, a cost which continues to fall as the process becomes more efficient through technological advancements and experience. Additionally, it's prudent to point out that lower oil prices are most detrimental to countries particularly unfriendly toward the United States. Most of all, low prices hurt Venezuela, a country notoriously anti-American and close in proximity to the United States. Iran is next and as their economy continues to suffer the U.S. gains strength at the negotiating table when trying to rein in their nuclear ambitions. Then there is Russia. While not a member of OPEC they are highly dependent on oil exports as they are a major oil producer. To date Putin has been able to flex Russia's strength and bully neighboring countries because of his strong national support. However, with the help of lower oil prices the Russian economy is expected to enter into a recession next year. When a country's population is struggling financially, that country's leaders tend to suffer the consequences through lower general support and unrest.
So what's this all mean for markets? While some of the more leveraged shale producers will struggle and possibly go bankrupt, the larger more efficient producers will continue to do well and we will likely see a needed consolidation in the sector if oil prices remain depressed for a protracted period of time. OPEC will most likely blink first in this price war as pressure on Saudi Arabia continues to mount from the other member countries. The broad energy market selloff, while justified, is possibly overdone and is opening up buying opportunities for investors. For example, pipeline companies have sold off in tandem with everything else "oil." These companies make their money by the volumes moved regardless of the price of the product being moved. They also pay attractive dividends, made all the more so due to our current low yield environment courtesy of the the Fed. Natural gas has been under pressure along with oil as they are generally produced together. However, natural gas has a current seasonal advantage and should rebound in the near term with the coming winter. With winter expected by meteorologists to be more severe than last year and natural gas reserves below their 10 year average, a price spike is expected. Also, large integrated oil companies, those that not only produce oil but refine it as well, have now reached oversold conditions. While they suffer from lower oil prices in their production divisions they actually benefit from the lower price in their refining divisions, which offsets some of that lost revenue.
Consumers of oil products, namely gasoline, benefit from the lower price in oil as well. The national average cost for a gallon of gasoline is now $2.67, the lowest average since 2010 and more than $0.90 per gallon less expensive than in April of this year. Consumers will spend $75 billion less this year on gas and odds are that money will find its way into other areas of the economy. The retail sector is slated to be a possible beneficiary this holiday season. Businesses will also benefit from lower shipping and production costs. Goldman Sachs estimates a boost to overall GDP of 0.4% next year, a number that could end up being much higher if the price war continues longer than expected.
Finally, lower oil prices keep the official inflation figures lower allowing for the Federal Reserve to keep interest rates at historic lows for longer than they might have otherwise, providing additional stimulus to the economy. Overall, lower prices are a net positive for the U.S. economy. We believe we've reached or are very near to reaching a bottom in oil prices and are likely to see a more sustainable price near $75 per barrel in the longer run. The U.S. economy will ultimately benefit while some of our government's least favorite countries will suffer. In the meantime the rapid selloff in the oil sector is creating a once in a decade buying opportunity for many consistently profitable and well run companies that wouldn't otherwise be trading at such discounts to future earnings.
This article contains the opinions of the author but not necessarily the opinions of Vulcan Investments, LLC. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.