Tuesday 31/03/2020

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The oil price on the move: less for more?

Fundamental Equity Buy Side Analyst Technology, Media, Telecom Europe

In a nutshell:

  • OPEC countries agreed on reducing oil production which will lead to a quicker rebalancing of the supply and demand of the oil market.
  • This marks a fundamental change from the prior policy of the cartel to push out of the market some of the competition (that carry higher production costs) by flooding the market.
  • Non OPEC producers have drastically reduced investment in future projects in order to cope with the lower oil price environment and this will have negative implications for non-OPEC non-US production in the coming years. Our view remains that the oil price will rise as a result of the above and that European integrated oil companies will be able to maintain their dividends.

The announcement

At the end of September, OPEC surprised everyone in the market by announcing a production cut ranging from 0,7 million barrels per day(mb/d) to 1,2 mb/d in order to accelerate the rebalancing of the oil industry. This announcement marked a clear shift from the market share gain strategy implemented by the cartel since November 2014.

The headline news was clearly positive but many commentators remained skeptical on how this ambitious target would be implemented and if members of the cartel would agree on how to split the cut between them.

Last week, OPEC finally provided the missing details on the cut and surprised a second time commentators by reaching a consensus to reduce production by the maximum amount previously announced and by revealing the commitment of non-OPEC countries to curtail their own production by an additional 0,6 mb/d.

This total 1,8 mb/d cut is quite sizeable and will bring the oil balance back into deficit (demand outpacing supply) as soon as the beginning of next year while our previous expectation was for a rebalancing to happen in the second half of 2017. Global oil inventories will therefore finally start their long process of normalization back to their historical average.

Has the former policy reached its goal?

The openly admitted goal of the prior policy of OPEC was to force high cost producers to curtail their investments and push uneconomical production out of the market. For what we are concerned, we are of the opinion that the market share strategy of OPEC (read Saudi Arabia) has been totally effective even if this has come at the expense of intense domestic economic pain; Saudi Arabia has been running a budget deficit in excess of 10% since their decision not to cut production in Nov 2014.

With its strategy, OPEC has been able to turn an annual non-OPEC production growth of 2.6 mb/d in 2014 into an annual non-OPEC production decline of 0.9 m/d while its own production has been rising significantly in the meantime. So the numbers are clearly indicating that the market share strategy of OPEC has been working.

It is now time to reinvest

This decline in non-OPEC production has been mainly driven by an impressive cut in investment of around 25% in 2015 and 2016 respectively as companies have desperately tried to adapt their business model to the lower oil price environment (in a lower oil price less projects are profitable which means you invest less as a company) and to protect their sacrosanct dividend without impairing too much their Balance Sheet.

The problem is that so far, 2017 is not expected to see a material acceleration in investment from conventional players as they are only willing to invest in projects returning more than 15% in an oil price scenario of USD 50-60 per barrel. Needless to say that the amount of conventional projects offering those kinds of return on investment are not abounding at USD 50-60. This means that international oil companies will remain very selective with their investment decisions in the foreseeable future in order to avoid the mistakes of the past by investing in less resilient projects on the basis of unrealistic oil price assumptions (i.e. ever rising oil price).

In our view, this lack of investment in conventional projects will have significant negative implications for the non-OPEC, non-US production profile in the coming 5 years (as it generally requires 3 and 5 years to develop a new oil field). This lack of conventional investment will have to be offset by a significant increase in production from short cycle production (US shale) and by new production coming from OPEC in order to keep the supply demand into balance..

On top, we are of the view that shale oil is not as homogenous (read that breakeven is not the same everywhere) as many believe and that the recent decline in shale breakeven contains an important portion of cyclical factors that should revert once activity starts to pick-up again (and push breakeven price higher).

As such, we think that if we want to incentivize higher long term investments (in conventional and shale projects), the oil price will have to rise further (which could possibly partially explaining the recent shift in OPEC strategy) and we therefore remain constructive on the directional trend of this commodity for the coming years; similar to the view we expressed at the beginning of the year.