Yesterday’s announcement by OPEC (The Organisation of Petroleum Exporting Countries) on cutting oil supply marks a significant change in strategy and effectively provides a back-stop for the oil & gas industry. OPEC said that it will reduce oil supply by 1.2 million barrels per day (mb/d) with a production ceiling of 32.5mb/d. Non-OPEC producers are also expected to remove an additional 600 thousand barrels per day (kb/d) of production. This target, if met, will bring oil markets to a supply deficit in early 2017. Oil inventories remain high, but the market will likely look through this as inventories continue to drawdown.
The agreement will also run in parallel with the promised cut by non-OPEC producers. OPEC highlighted that Russia is committed to reduce production by 300kb/d alongside several other countries who will also reduce their output by 300kb/d in aggregate – a further meeting is expected in early December to clarify these additional non-OPEC cuts. OPEC will establish a monitoring committee, who will work in combination with the OPEC secretariat, to monitor compliance with the ‘adjustments’. The agreement is to be effective from 1 January 2017.
What does it mean?
To put the ceiling of 32.5mb/d into context, in Q3 2016 OPEC produced 33.5mb/d and the International Energy Agency (IEA) estimates global oil supply in the same quarter was 97.2mb/d with global demand at 96.9mb/d. Oversupply of 0.3mb/d in Q3 2016 compares to an average oversupply of around 1.1mb/d since the beginning of 2015. The IEA forecasts demand growth in 2017 at a similar level to 2016. Depending on the pace at which these cuts are implemented, we will likely be in a supply deficit during the first half of next year. Inventories have been a major concern – total OECD oil and product stocks are around 3.1bn barrels, that’s about 400m barrels above the four-year average. This will take time to normalise.
Clearly caveats apply regarding this announcement, the likelihood of its implementation and the difficulty in quantifying the price impact of the cuts. But taking it at face value – the market potentially being undersupplied over the course of 2017 – near-term, this deal will initially ‘lift all boats’ in the energy sector. Further out, next year and beyond, some of the key implications for the energy sector will be:
- The US onshore goes back to work with gusto
Shale oil offers an upstream investment opportunity which has (in theory) attractive returns, shorter cash cycles and flexible investment levels. The effective cost of capital in the US was already low (approx. $38bn in fresh equity issued to the sector over the past 12 months), but this will open the flood gates. Most US onshore exploration and production companies (E&Ps) have guided to increasing activity (probably on an exponential trajectory) between $50-$60/bbl. This announcement arrives just in time for 2017 budget setting so I would expect that they will err on the side of optimism when plotting next year’s course. A pick-up in production will benefit the E&Ps as it drives earnings growth, but valuations are rich and it will pay to be selective.
- The true beneficiary of a US resurgence will be the service companies
With E&Ps being incentivised/committed to grow aggressively, capital investment will ramp up. Through the downturn we have seen service intensity rise as well as grow in size and service requirement. This trend will translate to a greater demand for completion and production services which will likely benefit oil services over E&Ps in the US.
- Integrated oil can still work
As the integrated oil companies continue the process of adjusting their businesses to the lower oil price environment, targeting lower ‘cash breakeven’ (cash from operations = capex + dividends), this announcement will make that job a lot easier if prices continue to rise. There has been a significant shift in the businesses’ cash dynamics and as such, in a more benign environment, dividend yields of around 7% at Shell and BP both look too punitive – they have historically traded closer to 5%. I would also note that the balance sheets of the integrateds will take time to de-lever, and in that period these traditional acquirers are unlikely to be present in the M&A market in a significant way – this has implications for those E&Ps that depend on asset sales to support their cashflows.
- Cycle begins again
Longer-term, this green light for US production ultimately takes us full circle back to where we started – a situation of excess supply. (See my previous blog). However, companies have indicated it will take around a year before we see US production begin to grow again meaningfully. In addition, non-shale-non-OPEC production is expected to move into decline, due to under-investment, towards the end of the decade, so arguably an up-cycle could last longer than the trajectory of US onshore production might suggest. However – and no surprises here – it will remain a cyclical business.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.