Note: This story was originally published on Prism Investor.
We’ve been busy meeting with the oil & gas C-Suite over the past few months, and a few trends have emerged. Much has happened since our last post on the global oil markets back in November 2017, but our outlook has not changed.
In our post Un-Happy Anniversary – Our Take on Oil Markets Ahead of OPEC’s Meeting, we noted that “If current trends persist, we can see U.S. production hitting 10 MMBopd in 2018, driving U.S. oil exports to new highs,” based on our conversations with industry about future capital budgets and expected increases in drilling activity. And, that is exactly what happened. In February, the U.S. Energy Information Agency (EIA) confirmed that U.S. crude oil production crested the 10 MMBopd threshold in November 2017, the highest level of output since the 1970s.
Little did we know that oil production was reaching the 10 MMBopd mark as we spoke, as it took some time for official statistics to confirm our prediction. What that means is that, all other variables held constant, the Permian Basin region of west Texas could meet the world’s entire incremental crude oil demand for the next 12 to 18 months by itself.
The Buzz Ahead of OPEC’s Meeting
Apparently sensing a tightening in the oil markets brought on by falling crude inventories, CNBC reported that Scott Sheffield, executive chairman of Pioneer Natural Resources (Nasdaq: PXD), one of the Permian Basin’s largest E&P operators, said, “If OPEC doesn’t do something I think we will see $100 oil price.” In our opinion, Mr. Sheffield’s $100 scenario is unlikely, because we believe OPEC is likely to be increasing output.
Oil prices have already come off their recent highs by approximately $10 per barrel, falling from the mid-$70s only four weeks ago to the mid-$60 range today. The alliance between OPEC leader Saudi Arabia and Russia to maintain production levels was already seen as an uneasy one, and given recent chatter in the press of those nations wanting to increase output makes it, in our view, more likely that we will see the cartel announce an agreement to increase output. That would dampen bullish expectations that market perception will flip from being supply-driven to demand-driven.
As OPEC considers its options, we anticipate cartel members are agonizing over how to explain a production increase that balances these factors, among others:
- Declines in production from Mexico and Venezuela.
- Likely future reductions in output from Iran resulting from expected renewed U.S. sanctions.
- Continued pressure on the domestic budgets of oil producing nations.
- Increased defense spending by Saudi Arabia to combat the Iranian-backed insurgency in neighboring Yemen and a growing. Iranian threat in the chaotic regions of nearby Syria.
- Loss of market share in the fast growing economies of India and China to U.S. producers.
- Uncertain timing of a Saudi Aramco IPO.
- Continued growth in U.S. oil exports amid a flood of crude production from unconventional resource play.
- Rising price differentials in the Permian Basin resulting from temporary infrastructure bottlenecks.
- Continued weakness in U.S. oilfield services pricing, shoring-up drilling economics in the Permian Basin and other prolific plays in North America.
This list could go on, and it will take a deft hand to communicate a production increase without panicking oil traders that OPEC and Russia are going to flood the market with production to recapture market share.
Our evaluation of the four potential scenarios coming out of OPEC’s upcoming meeting:
- Production cuts. If the cartel makes this improbable decision, then oil prices could run-up to levels predicted by Sheffield, but we give this option very little probability of occurring.
- Modest increase. If the cartel increases production modestly, as most expect, we may see some initial bump in crude prices based on the avoidance of a worst-case scenario, but those gains will be hard to hang onto.
- Big Increase. We don’t see this happening.
- Maintain production levels. If OPEC announces it will maintain current production levels, then we would expect oil traders to take a bullish stance, at least in the short term.
As we mentioned earlier, we expect the cartel to announce a policy of modest production increases. Consequently, we do not expect a sea change in market perception and continue to believe as we did last November that oil markets are supply-driven and prices will remain tepid.
Recent Observations on Investor Activity
After analyzing recent moves and sentiment expressed by institutional investors, here are some additional factors for investors to consider:
- We have identified renewed interest in energy stocks among generalists (read: long-only mutual funds) which is, and please forgive the play on words, “generally” a good thing. However, we expect that generalists are only testing the waters and evaluating the E&P and oilfield services sectors only in anticipation of a strong upward trend in commodity prices. More than one investor has quipped, “I don’t mind missing the first 20% gain if I can capture the next 80%.” That sentiment does not give us confidence the market has conviction in a bullish trend.
- We are not convinced that OPEC will give the market confidence that they are reigning-in supply, in fact the opposite is more likely.
- As we noted just last month, G-R-O-W is a Four-Letter Word in the E&P Space. Meaning, since 2014 growth investors and generalists (read: mutual funds) have abandoned the energy sector, with the void being filled by investors adhering to value and alternative investment styles. Without growth investors entering the market, there is no one for the value crowd to sell into. If OPEC doesn’t give the market news that will flip sentiment to demand-driven, the value and alternative investors will have to maintain patience.
The Bottom Line
Making point estimate price predictions in a complex global market is fraught with error, and we do not purport to command any authority when it comes to forecasting oil prices, Instead, we focus on directional changes and provide readers our views with a window into our thinking and analysis, and then let them decide. With that caveat, we maintain our view that the global oil market will continue to be supply-driven and OPEC is likely to put more barrels on the market, precluding a reliable upward trend in crude oil prices in the short-term.
After OPEC’s announcement on June 22, all bets are off.