By Dana McGinnis, Chief Investment Officer. Published 11/30/18 by Hedge Connection and reprinted with permission.
How should investors consider recent developments in the general energy (oil and gas) business? The big surprise, beginning in early October 2018, was not only the swift decline in the price of oil, but the magnitude. This development was caused by several reasons. First, the two-year-old strategy of the OPEC players and Russia to sop up excess supplies and raise prices worked. Prices had risen from around $30 per barrel to almost $80 for Brent over two years because supply and demand had become balanced. There was even a threat of a shortage with looming sanctions on Iran’s ~3MM barrels a day. Bear in mind that the price declines, which started going down in 2014 were caused by the extraordinary rise in oil production in the U.S. attributable to the implementation of new extraction technologies including fracking.
As oil prices approached $70 and $80 in the early summer of 2018, the Saudis and the Russians put more oil on the market. The Saudis did so because they had spare capacity. The Russians, because they were able to lower their costs (lower Ruble values and lower taxes) also added to supply. Russia too, has sanctions on its economy. The Russian oil business, however, is now believed to be profitable. In addition, the Saudis and the Russians — and despite pipeline shortages in the Permian Basin (unique petroleum region covering 70,000 square miles of Texas and New Mexico) — the U.S. also raised production. Most everyone was ignoring increasing supplies until the U.S. administration issued waivers on about 1MM barrels of Iranian production. Then oil prices lost their support, so to speak, and prices started to decline.
The next thing that was a bit of a surprise was the pipeline shortage in the Permian which was intended to be resolved by mid-2020. Now the timeline has been moved up to late 2019. The market anticipated that there would be another glut unless something changed. The only solution was for OPEC to cut supplies in hopes of raising prices, at least for a time. I think this is what they will do and Russia will fall in line despite defiant talk. The Russians did agree to cut production as of November 29, 2018. I now believe that prices will rise somewhat, though not a lot, and the market will then just wait on news from the Permian.
There are many unknowable factors that will play out in the coming months. Will the waivers of Iranian sanctions (which are temporary, by the way) be eliminated in six months as advertised? If so, who will replace the oil to India, North Korea, Japan, China? The most important issue after OPEC cuts production in December, presumably, will be whether the new oil coming from the Permian will depress prices again, possibly to new lows.
I think the pressure will certainly be there from the Permian as production will continue to flow and rise for years. What happens in this case? One cannot guess the price, but in the Permian $50 oil or higher is fine with producers if they can sell all they want. Of course, they would rather have $60 oil, and they might get it. Relatively low prices will hurt almost all producers except the U.S. (and in the U.S., it is the Permian almost alone that will prosper.) Russia, and some smaller Mideast producers will not be hurt by that price. Low prices will be a tailwind for the U.S. economy and most economies in the world, (those who allow low prices to be passed on the consumers). The U.S. will be in excellent position to apply maximum pressure from a foreign policy point of view on any so-called bad actor countries, except for Russia and possibly China.
The most likely scenario, as I see it, will be oil prices settling around $60 and staying there for quite some time. This is a perfect scenario for the U.S. and for the Permian. Most small players will suffer as will oil-dependent economies. The Saudis and OPEC will struggle. It is not all a bed of roses, but it will be for the Permian Basin.