Is “lower-for-longer” the new normal for oil?

Is “lower-for-longer” the new normal for oil?

Now that OPEC has published its closely watched annual World Oil Outlook, all eyes are on what the oil producing organization sees for the future of oil. As the price of West Texas Intermediate crude in the United States, as well as the international Brent benchmark, have each fallen by more than 50 percent from the highs seen two years ago, the entire energy sector is wondering when prices will climb back to their peaks.

Hopes for a quick recovery in oil prices may be dashed. Not only has OPEC signaled little to no intention of reducing its oil output, but the organization now forecasts prices to rise only modestly through 2020. Due to the unrelenting production of OPEC and other major oil producers including the United States, demand is not expected to diminish nearly enough to cause oil prices to rally. OPEC does not want to cut production and risk ceding market share to other major oil producers like the United States and Russia, which have not cut their own production. This has caused a great deal of disagreement between the various OPEC member nations, many of which are now suffering steep budget deficits, like Saudi Arabia.

The supply conundrum is exacerbated by the prospect of Iran ramping up its own production. Iran currently produces about 2.8 million barrels per day, and thanks to the easing of economic sanctions late last year, analysts expect the nation to add between 600,000 barrels and 1 million barrels to its current production this year.

As a result, analysts, investors, and the entire oil and gas industry should prepare themselves for a new normal for oil—lower prices, for longer.

OPEC Resists Calls to Cut

As the old saying goes, the cure for low oil prices is low oil prices. In response to sub-$40 crude, Big Oil hoped that its supply cuts, in conjunction with low prices, would spur higher demand, and thus higher prices, going forward. But Big Oil’s cuts are to be too little, too late. After only modest cuts in spending in 2015, oil majors Chevron (NYSE: CVX) and ConocoPhillips (NYSE: COP) are set to cut capital expenditures by 24 percent and 25 percent in 2016, respectively.

In doing so, the industry hopes to ease some of the global supply glut that has caused crude’s precipitous decline over the past two years. By starting to turn the taps off, major oil companies hope to put a floor under the price of oil. However, curtailing spending takes several months to ripple through the energy industry. Big Oil made only slight cuts to capital expenditures in 2015 and 2014, as the industry held out hope for a milder decline in the price of oil, followed by a speedier recovery. That has not happened, which has dampened hopes for a 2016 rally.

And, prospects of a near-term rally in oil prices are further diminished, because Big Oil is not getting any cooperation from OPEC. What OPEC does with its own production is the big question and is likely to be the major driver of oil prices, particularly on the international stage as it pertains to Brent crude. But in that regard, OPEC has so far resisted calls to cut production. Investors can recall OPEC’s major announcement in November not to cut production at its most recent meeting. OPEC is now getting pressure to cut production from many nations, even from its own members. For example, Iran has voiced support for meaningful production cuts, and there is growing discord within OPEC.

Still, OPEC’s decision sets the stage for a lower-for-longer oil price environment. As a result of its actions, OPEC sees just $70 oil by 2020. Moreover, it does not see a return to $90 oil until 2040.

Implications for Investors

In its annual report, OPEC’s own expectations are for demand to grow only slightly this year, to 31 million barrels per day, in response to lower oil prices. In a foreword to the report, OPEC Secretary-General Abdullah al-Badri wrote that the impact of the massive decline in oil prices is likely only to be felt in the short-term. Over the medium term, even OPEC itself acknowledges its unwillingness to cut production is likely to keep a more pronounced rally in check.

OPEC expects demand to dip only slightly, to 30.7 million barrels per day by 2020. That represents just 300,000 barrels per day less than current demand. And, supply projections do not even include contributions from Indonesia, which rejoined OPEC this month.

The reason why OPEC has kept production steady, a decision that flies in the face of traditional market economics, is because of its desire to retain market share. OPEC does not want to be the only one to cut production, only then to see rival oil producing nations grab market share and enjoy the benefits of higher prices. In this area, OPEC’s strategy is likely to work. It foresees its own market share climbing to 37 percent by 2040. But OPEC’s market share grab is coming at a steep cost, even to itself, in the form of painfully low oil prices.

As a result, investors should brace themselves for sustained low oil prices. Many smaller oil and gas producers in the United States have gone bankrupt, and while the industry is trying to ride out the storm, more bankruptcies will come to pass if oil prices stay around $40 per barrel through the next five years. The key takeaway for investors is to carefully review company balance sheets and cost structures, to avoid the companies that cannot finance their debt obligations at such low oil prices.

 

Companies to Watch

In addition to Chevron and ConocoPhillips, investors should pay close attention to the actions of Exxon Mobil (NYSE: XOM). Exxon Mobil is the largest publicly-traded energy company in the world, with a market capitalization in excess of $300 billion. As such, when Exxon Mobil speaks, the energy world listens. Exxon Mobil has announced plans to cut capital expenditures by 22 percent in 2016, keeping up with its industry peers. The collective actions of U.S. oil firms may not be enough, however, as OPEC’s over-production continues to weigh on global oil prices.

Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance. 

 

Originally published on January 6, 2016