OPEC Stands Firm: The Wake
On November 27, OPEC ministers got together and stood firm on cutting production. The cartel refused to cut even a single one barrel to support prices.
Within a few hours, crude futures (NYSEARCA: OIL) (NYSEARCA: USO) collapsed over $5 and settled around $69 per barrel at the end of the day.
Investors like myself were equally displeased with the reluctance of OPEC to act as a floor on prices, but after reviewing the fundamentals I believe that not only was this a prudent thing to do, it was desperately needed.
1) US Producers Were Going Out of Control
The graph below shows the world production of crude oil from 2009 to 2013. The increase is about 3 million barrels of oil or roughly 1 million barrels of oil per day a year. Now take a look at our second chart of the world oil production for the same period. World oil production rose from about 90.5 million to 93.5 million barrels of oil a day.
The US accounted for almost 100% of the 3 million world oil production increase during that period.
On a country basis, this increase is even more significant with the US going from 5 million barrels to over 8.5 million barrels in four years. Almost an 80% increase. No other country has even come close to this level of production increase. Given this level, there was no question that the market would be oversupplied.
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2) No cut sends the message that OPEC will not come to the rescue
Till yesterday, US based oil producers were on the edge of their seats hoping that they could continue to increase production while OPEC supported the price. This changed immediately yesterday when they realized that OPEC was going to stand firm. Now producers must take a hard look at their capital expenditure in the next 24 months and make the decision that if they want a healthy market with reasonable returns, they must cut production. Before the OPEC meeting some firms have begun cutting capital expenditure for 2015. I expect to see a more serious view of this going forward and more firms announcing a cut to their capital expenditure of 60% to 70%.
3) Short-term pain for long-term gain
If you look at the fundamentals, even a 1 million barrel cut by OPEC would do little to support the market and may even cause further weaknesses in the very short future with continued capital expenditure. The US producers would simply surge production to make up the difference.
OPEC realizes that the swing producer is the US shale players and must wake them up from their addiction to 'drill baby drill.' Many of the US plays have a high breakeven point above $75. On a cash flow basis, even previously at $90 a barrel oil, these companies were still cash flow negative.
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I view this development as chance for a world wide collective discussion on production, inclusive of both US players and the Russians. OPEC is willing to depress prices to make a point and bring everyone to the bargaining table. The faster they do this, the faster we can get back to realistic oil prices.
Where do prices go from here?
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That's the supply side. But the demand side remains excellent. World oil consumption is growing about 1.5 million barrels a year. A big amount of that is from China and India, very large countries with very small per capita consumption of oil. Both of which hardly produce enough oil themselves to ever become self sufficient. Secretly, I believe they could not be more happy with this price war.
Low prices spur demand and I expect to see this amount growing to 2 million barrels a year.
A lot will be determine by how soon everyone comes to the bargaining table. Remember that the Saudis have been here before, way back in 1985 (left side of graph) where they decided to dump the oil price and crash it to $7. Right now, we're seeing a price war. I see a quick rebound to about $75 a barrel as a sign of a peace treaty among all producers if they come to the table. That's a big 'IF.' After that, a very gradual price rise of a about $2 a barrel a year is more likely than the $90+ prices we had been seeing previously.
This will mark an end to the rapid shale developments and subsequent market crash starting with natural gas. Natural gas prices collapsed in 2012 to $2.50 mmbtu and have flattened around $4.00 for the last 18 months. Many players like Encana (NYSE: ECA) and Chesapeake (NYSE: CHK) jumped ship into oil. Now there's no where else to jump to.
I view this as a once in a decade flush out and a great opportunity to get hold of some really strong companies at depressed prices.
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