Thoughts ahead of the OPEC meeting

As OPEC (Organisation of Petroleum Exporting Countries) meets on 30 November to decide on production cuts, much uncertainty remains regarding OPEC’s collective appetite to reduce production, how the reduction will be apportioned and the likely timing of the mooted cuts.

We should not take OPEC’s actions lightly though as the period since 2014 has shown. When oil slid into a bear market in October 2014, as a result of increasing supply, hopes began to rise that OPEC would come to the rescue. OPEC dashed those hopes at their November 2014 meeting by choosing to take no action and then proceeded to do the opposite – growing production through 2015 and 2016. OPEC members called for the market to set the price and high-cost producers to respond accordingly. In an effort to reassert their dominance and enforce capital discipline on the sector we have seen the most severe and prolonged oil industry downturn in two decades.

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In the third quarter of this year OPEC produced 33.3mb/d (million barrels per day) of oil, 37% of global oil supply. This was up 2.3mb/d from their 2014 production levels – a year when the oil price averaged $100/bbl. On 28th September 2016 the oil price was $49/bbl and OPEC performed an about-turn, announcing a ‘production target ranging between 32.5 and 33.0mb/d, in order to accelerate the ongoing drawdown of the stock overhang and bring the rebalancing forward’.

If OPEC agrees on supply cuts this month it will clearly be positive for oil prices – the oil market is already rebalancing and cuts will help accelerate that process. However, we should remember that the oil industry has proven itself durable over many decades at many oil prices. With that in mind, it is important to focus on the actions of management teams and their workforces as that is a more critical factor than price in determining whether capital is allocated and operated in a disciplined and efficient enough manner to drive attractive returns for shareholders.

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OPEC, as the low-cost producer producing below capacity, has spoiled the energy sector with high oil prices. High prices hid a multitude of sins in the sector and allowed high-cost producers to flourish. The oil industry saw rampant cost inflation and poor investment decisions damage economic returns. With OPEC ostensibly having finished disciplining the industry we should not ask what direction for the oil price but instead, have the oil companies learnt their lesson?

A rising oil price will lift all boats initially, but we expect differentiation over the medium term. There will be those companies who have learnt a painful lesson and will continue to demonstrate capital discipline – allocating capital efficiently leading to improving shareholder returns. And there will also be those who can’t help themselves – returning to their profligate ways.

In the US, the exploration and production companies who drove the boom in shale oil are likely to go back to work aggressively. A regulation-lite Trump administration is likely to further accentuate another US boom. According to Bloomberg data, the US sector has raised $29bn in fresh equity this year already. With these upstream companies re-primed, we expect the US oil service names to benefit from a ramp up in spending. The integrated oil companies indebted balance sheets and dividend commitments require that capital discipline is maintained, but their resolve on dividends will be stretched to the limit. If they can bridge the cash generation gap then they may offer an attractive proposition, regardless of rising oil prices, as capital investment becomes productive and costs fall.

As ever, those companies (and investors) relying on OPEC to provide them with economic rent are likely to be an unsustainable proposition through the cycle, while those who are focused on allocating capital in a disciplined and efficient manner are the ones likely to prosper.


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