Nikhil Mahajan, CFA
Senior Equity Analyst
Producers, consumers, and investors have been shocked over the last 18 months by a nearly 70% drop in the price of oil. The sharp decline in price has resulted in huge declines in employment in the energy and mining industries and lower gasoline prices for consumers. This has also led to a significant increase in economic pressure among those countries heavily dependent on oil revenues for government spending. While no one can predict the ultimate bottom in oil prices, this Special Bulletin examines the reasons for the decline and the likely path forward.
Supply and Demand
In every free market, price is dictated by supply and demand. For 2015, demand growth is expected to be around 1.6 million barrels per day (MMbpd), which is strong, but not as strong as one would have expected given the freefall in prices. Over half of the annual growth in demand for oil in the later part of the last decade came from China – China's much-publicized economic slowdown has clearly had an impact on demand.
Interestingly and perhaps more important to the price of oil has been the shifting dynamic of oil suppliers. Specifically, the rise of domestic shale oil production over the last decade in the United States has greatly diminished OPEC's ability to set prices in the marketplace. OPEC has maintained production levels despite falling prices in order to force higher-cost producers out of the market. So far, this strategy has largely failed, creating an excess supply of about 1.4 MMbpd.
Earlier today the House and Senate passed a $1.1 trillion spending measure that incorporates lifting the 40-year old oil export ban. With a comprehensive and better than expected renewable energy piece included in the legislation (solar and wind tax credits, etc.), the bill is expected to be approved by the President, eventually becoming a law. In the very long run, this could imply significant competition to oil from these renewable resources. In the medium term, this implies an increase in North American oil production. Given the ability of domestic shale producers to ramp up production, North America could become a swing producer for oil – this is a very different global and geopolitical dynamic than what existed over the last couple of decades.
The decline in price has resulted in massive global rig reductions, most notably in the U.S. and Canada. Canada's rig count is down 71% from its peak in 2013, while the U.S. rig count is down 59%. International rig count is down just 16%, primarily because of larger/longer projects internationally (deepwater and national oil companies) and because national governments need oil revenues to balance their budgets.
Despite the sharp reduction in rig count, U.S. crude oil production is still very high. Production is down approximately 350,000 bpd from the end of 2014 but still above 9 million bpd. Producers have become increasingly efficient by using newer drilling techniques and by focusing on core acreage areas. Producers are pumping more from a diminished number of rigs and have not shut in significant levels of production.
With large debt burdens that require servicing, oil exploration companies have chosen to keep the taps flowing in order to generate revenue. Shutting down rigs and cutting jobs has allowed them to lower their breakeven prices, but most U.S. shale oil producers are losing money at the current level of West Texas Intermediate (WTI) oil (about $35 per barrel). Furthermore, the excess supply of oil is rapidly filling the capacity of storage facilities in the U.S. Clearly, this is an unsustainable situation, and production is beginning to decline as smaller producers exit the business.
In recent months, crude oil speculative contract positions have declined significantly as seen in the chart below. A rebound in these positions could lead to a near term increase in crude prices. But longer term supply demand fundamentals should keep a lid on rapid price increase.
Over the course of last year, the WTI futures curve has continued to shift downward. Currently, the curve sits at the lowest level over the last 18 months with three to five year futures prices around $50 to $55 per barrel.
According to Ponderosa Advisors, only a small percentage of U.S. shale oil producers are profitable at the current level of prices (assumes natural gas at $2.75 per million British Thermal Units [MMBtu]). Significant additional production would be profitable as WTI nears $50 per barrel, and most of the U.S. production base is economic with WTI below $65 per barrel.
As a result, we believe that overall weak global demand and limited excess capacity (resulting in high storage costs) will serve to constrain production in the near term, helping to keep a floor under prices. However, producers eager to capitalize on higher prices are likely to prevent oil from rising above $50 to $55 per barrel until global demand accelerates.
Our Outlook for Energy Securities
In our core and mid cap equity strategies we have been underweight energy. We have focused our holdings on high quality companies in the integrated, E&P, and oil services sub-industries.
Integrated and Exploration & Production (E&Ps) Companies: Large capitalization integrated and E&P companies with strong balance sheets, good asset base, and able management teams should be the survivors. Integrateds benefit from steady performing chemical and refining assets. E&Ps that did not use significant capital (especially debt) to acquire land at much higher prices of oil in the last five years should be survivors too. These two sets of companies could eventually pick up attractive assets at distressed valuations if and when private capital flows into the industry slow down.
Oil Services: This industry continues to be extremely challenged, operating at cash cost levels. It appears pricing cannot go down further, but there is tremendous oversupply in the market, which makes the potential for price increases unlikely in the next several quarters. With this as the backdrop and debt still high at many firms, bankruptcies seem unavoidable unless macro conditions change. Large capitalization services companies should be the beneficiaries in the longer run.
Master Limited Partnerships (MLPs): There are two major impacts of the depressed energy commodity price on the MLP sector: 1) an increasing capital market constraint for the energy industry in general, and 2) the growth in counterparty risk (i.e., some E&P customers of the pipeline network). MLPs usually rely on raising additional capital to support their organic growth projects. The distressed energy capital market has made raising additional equity increasingly uneconomical. MLPs either have to cut back on their growth capital projects or consider funding them with distribution reductions. In addition, while City National Rochdale has generally invested only in midstream MLPs whose incomes were secured by long-term take-or-pay or regulated contracts, those contracts are now viewed with more uncertainty given the weakness in the E&P sector. If an E&P counterparty fails due to low commodity prices, its contracts will be renegotiated. While the downside to revenues for the midstream MLPs are likely limited in our view because the molecules in the ground have little value to the creditors without market access, the potential disruption scenario is putting further pressure on the sector. In addition, the sector is suffering from weak trading sentiment, redemptions, and broad based selling by energy specialized funds. The weak energy market coupled with increasing capital constraints is currently holding back any meaningful buying from potential value investors.
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