OPEC: Oil price volatility and stock buying opportunities

Transcription

1 For professional investors only OPEC: Oil price volatility and stock buying opportunities December 2014 Global oil prices have fallen precipitously Ministers from the Organisation of Petroleum Exporting Countries (OPEC) decided to leave current oil production quotas of 30 million barrels per day (mnbpd) unchanged on 28 November, resulting in a 10.2% decline in the West Texas Intermediate (WTI) oil price to US$66.15 a 35% decline since its June high. Brent crude plummeted to a five-year low of US$68.99 following the meeting, down by 38% since mid-june. World oil prices did rebound at the time of writing on 2 December after data showed that lower oil prices may be affecting more marginal production with a 15% drop in permits issued for new US shale oil wells in October. A weaker US dollar also served to boost commodity prices. A weaker greenback improves the purchasing power of European and Asian buyers for dollar-denominated commodities. Brent crude rose by US$2.39 or 3.4% to US$72.54 a barrel (bbl). Not surprisingly, global energy equities have fallen equally hard, with oil and gas producers and service providers the most affected. While such sharp moves in commodity prices tend to fuel conspiracy theories, we prefer to focus on the facts: supply is simply running ahead of demand. Chart One: WTI front month crude oil price, US$/bbl US$/bbl Dec 2013 Jan 2014 Feb 2014 Mar 2014 Apr 2014 May 2014 Jun 2014 Jul 2014 Aug 2014 Sep 2014 Oct 2014 Nov 2014 Source: Bloomberg, as at 1 December Chart Two: Brent front month crude oil price, US$/bbl US$/bbl Dec 2013 Jan 2014 Feb 2014 Mar 2014 Apr 2014 May 2014 Jun 2014 Jul 2014 Aug 2014 Sep 2014 Oct 2014 Nov 2014 Source: Bloomberg, as at 1 December

2 Yet the market is not currently oversupplied A persistent surge in growth from shale oil in North America has been met with an unexpectedly early return to production (Q2 onwards) from previously impaired OPEC members such as Libya, at a seasonally low point for global crude demand (which typically bottoms through Q2/Q3 every year before peaking in Q4). However, with OECD crude and product inventories currently sitting below their five year average, the global oil market is not currently oversupplied. As expected, the market is worried about an oversupply in the months ahead. Chart Three: Quarterly global oil demand as percentage of average annual demand, E Source: International Energy Agency (IEA) Monthly Oil Market Report, as at 30 November *Average annual quarterly / annual demand. Chart Four: Total OECD crude and petroleum product stock levels, YTD Source: Bank of America Merrill Lynch Commodities Research, as at 24 November

3 It s next year the market is worried about As ever, equity (and commodity) markets are always trying to price in the future. It is for this reason that oil prices have dropped and along with it energy equities. Looking into 2015, the simple maths shows that the market is likely to be oversupplied to the tune of about 1mnbpd. 1 As the self-styled swing producer, OPEC was therefore expected to cut its current output of 30.2mnbpd 2 by a similar magnitude. Instead, OPEC decided to leave their current quote of 30.0mnbpd unchanged. Since OPEC is the lowest cost producer, the next logical step is for prices to drop sufficiently to choke off the marginal producer not surprisingly prices have plummeted in the search for the weakest link. Yet, as the market spits out the proverbial dummy, some context is helpful. On the one hand, OPEC is a cartel in name only. Cohesion is loose at best; non-existent at worst. It has been slow to react on many occasions in the past, yet surprisingly production has typically followed its self-enforced quota in the past [blue line represents OPEC quota]. Since OPEC themselves forecast a call on their crude of 29.5mnbpd in 2015, there is already an implicit reduction in output tabled for next year, given the current output of 30.2mnbpd. Put another way, OPEC had already envisaged a cut to their output of 0.5mnbpd into next year, based on their current 30.0mnbpd quota, and 0.7mnbpd against current production. Chart Five: Production typically follows quota (OPEC production and quota, mnbpd) Source: IEA, OPEC, Morgan Stanley Commodities Research 19 November *Apr-Jun 2000 excludes Iran; Nov 2006 Dec 2007 excludes Angola and Ecuador, but includes Indonesia; Jan-Sep 2008 includes Indonesia. Chart Six: OPEC s own forecasts show lower production in before recovering later in the decade (OPEC production, mnbpd) OPEC production (mnbpd) Source: IEA, OPEC, Morgan Stanley Commodities Research, as at 19 November International Energy Agency, Bank of America Merrill Lynch, Morgan Stanley, Macquarie, Credit Suisse and UBS. 2 Morgan Stanley Commodities Research, Macquarie Commodities Research. 3

4 A US$1.4 trillion economic stimulus When prices move fast in any direction it is difficult not to get caught up in speculation, gyration and even capitulation. Lower oil prices reduce revenues for upstream producers and in turn this reduces their ability to spend money with the service providers: no one wins. If you take a step back and look at the numbers, the near US$40/bbl drop in oil prices since June, has just gifted the global economy an annualised stimulus of US$1.4 trillion (~2% of global GDP). To put that in perspective, it is almost twice the size of the stimulus announced by the US government as part of the American Recovery and Reinvestment Act (ARRA) in It is estimated that for every 10% drop in oil prices there is a commensurate increase in global oil demand of 0.3%. All else being equal, this means that a 35% drop in oil prices will lead to an increase in global demand of almost 1mnbpd: ironically almost the exact amount which the market currently estimates needs to be shaved from supply to balance markets. Put simply, today s low oil prices will drive tomorrows higher demand. OPEC: The reports of my death are greatly exaggerated 4 Much speculation has been bandied around that OPEC is at an end. 5 One meeting does not signal the end of a cartel that has been in existence since Speculation has also been rife that OPEC, and specifically Saudi Arabia, is intent on driving down prices to force US unconventional producers out of business and reduce Russian political influence in the Middle East. 6 While it would be foolish to dissect the inner thoughts of the political aspirations and ideals of any politician, let alone those of the OPEC member countries, it is worth dwelling on the mathematics. After all, money talks louder than politics. As the largest producer, and the only one with any real spare capacity, Saudi Arabia has long been the protagonist within the cartel. Analysis shows that in order to balance the books, Saudi needs US$90/bbl 7. Yet, with some US$1 trillion in reserves it is hard to imagine Saudi Oil Minister Ali Al- Naimi sweating under the pressure of (currently) lower oil prices. As conjecture sweeps the popular press as to whether we will see a rebalancing of the market, Saudi s Oil Minister will not need a financial calculator to figure out that from the roughly 7 million barrels his country exports on a daily basis he is now earning almost US$2bn less every week than he was just six short months ago. On an annualised basis, that is about the same size as Puerto Rico s 2013 GDP. 7 To be sure, Saudi is not in an immediate hurry. That said, Venezuela, Iran, Iraq and Russia collectively account for almost 20mnbpd. According to the Financial Times 8, these countries require an oil price of between US$110/bbl and US$160/bbl to balance their books ; that is roughly one quarter of world crude supply. The best cure for low prices is low prices Fear and greed are two sides of the same market coin. We would contend that it is the former that is gripping the collective imagination today. Moreover, with the fall-out in global energy equities (exploration and production companies are down >30% from mid-june), the natural question to ask is where to from here? This requires some perspective. On the one hand, world population growth has not suddenly slowed in the wake of lower oil prices. On the other hand, the global economy cannot avoid the positive tailwind of a trillion-dollar-plus stimulus. Population and economic growth are two core pillars of long-term demand for energy. Looking longer term, this will ensure that consumption of energy in general, and oil in particular, will continue far into the future. In the short-run the path to a more balanced market (and by extension higher prices) is unlikely to be swift, nor direct. Yet, with global decline rates in oil production running at 5%, the world needs 4mnbpd of new production every year simply to stand still. Opportunities for investors as strong get stronger It is conceivable that more pain could yet be felt across the energy industry in the months ahead companies with poor quality assets and weak balance sheets may not survive. It is for exactly this reason that our global resources strategy only focuses on those companies with the highest margins, strongest balance sheets and best management teams. We firmly believe that this current low in the cycle will present significant opportunities for these companies and it is for this reason that we are sharpening our energy investment pencils. First State strategy Given this challenging backdrop, the First State strategy continues to benefit from focusing its exposure to high quality names within the mining and energy sectors. In our view, companies with larger than average margins and strong balance sheets are better placed to withstand heightened fluctuations in commodity prices. For example, super major oil company, Exxon Mobil, continues to display resilience in a falling oil price environment, with cashflow growth adjusted for debt remaining very competitive against its peers due to a combination of organic growth and share buy backs. The recent retrenchment in energy prices also presents both us and our investors with some excellent buying opportunities and some interesting relative value situations particularly exploration, petroleum and gas names companies with assets in Canada s Montney region (ie. Seven Generations Energy, Peyto Exploration and Arc Resources) and the Permian Basin (ie. Diamondback Energy and RSP Permian) in the United States. We are targeting those names with the lowest production costs in anticipation of an expected tailwind in the natural gas price leading into the North American winter, as well as the fact that the Permian Basin has some of the most robust economics of any US onshore oil production area. 3 Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output from October 2011 through December 2011, Congressional Budget Office, February The expression derives from the popular form of a longer statement by the American writer, Mark Twain, which appeared in the New York Journal of 2 June 1897: The report of my death was an exaggeration. See more at: 5 The End of OPEC, Global Energy Weekly, Bank of America Merrill Lynch, 27 November Saudi Arabia Absorbs Lower Oil Prices, FT Online, 8 October World Bank Development Indicators, 1 July How Low Can It Go, FT Weekend, 8-9 November

5 Institutional Relationship Management Chris Gower Head of Client and Consultant Relationships, EMEA +44 (0) Lucy Johnstone Consultant Relationships +44 (0) Denise Saber Head of Institutional Business Development, Europe +44 (0) Frank Glennon European Business Development Manager +44 (0) This presentation is directed at professional clients only and is not intended for, and should not be relied upon by, other clients. The value of investments and any income from them may go down as well as up and are not guaranteed. Investors may get back less than the original amount invested and past performance information is not a guide to future performance. Investment should be made on the basis of the Prospectus and Key Investor Information Document available free of charge by writing to: Client Services, First State Investments (UK) Limited, 23 St Andrew Square, Edinburgh, EH2 1BB; or by telephoning between 9am and 5pm Monday to Friday; or by visiting If you are in any doubt as to the suitability of any of our funds for your investment needs, please seek independent financial advice. The fund invests in assets which are denominated in other currencies; hence changes in the relevant exchange rate will affect the value of the investment. The fund invests in shares in the natural resources and energy sectors which typically experience above average volatility when compared to other investments. Trends which occur within the general equity market may not be mirrored by the natural resources sector. The fund invests in a single sector, which offers the possibility of higher returns, but may involve a higher degree of risk compared to investments which spread investment risk through a variety of sectors. Share price movements may have a greater effect on the overall value of these funds.reference to the names of each company mentioned in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. All securities mentioned herein may or may not form part of the holdings of First State Investments portfolios at a certain point in time, and the holdings may change over time. Issued by First State Investments (UK) Limited which is authorised and regulated by the Financial Conduct Authority (registration number ). Registered office Finsbury Circus House, 15 Finsbury Circus, London, EC2M 7EB, number Telephone calls with First State Investments may be recorded. EX2512_1214 5