Oil prices have been testing oil bulls over the past few months. After the Organization of the Petroleum Exporting Countries (OPEC) announced in November 2016 that it would cut production, there was an initial rally to the low $50s. Oil prices have now steadied lower due to supply growth from the U.S., Nigeria, and Libya—the latter two OPEC countries were exempt from production cuts.
Oil bulls point to a historic production agreement from both OPEC and non-OPEC countries whose aim is to drain stockpiles globally. On paper, inventories ought to decline: production cuts plus demand growth (roughly 3mm barrels per day altogether) compares to supply growth in the US (+1mmbd expected by year-end) and Libya/Nigeria (+0.4mmbd).
There are other sources of production growth, namely Canada and Brazil, but there are also detractors like China. All in all, analysts peg an expected deficit of 0.5mmbd - 1mmbd. So why aren’t inventories lower and prices higher?
For one, the market had to work through 50+mm barrels of “floating storage” (the most expensive kind of storage) before physical storage levels draw. Secondly, after more than a year of production declines, US exploration and production companies (E&P) were eager to ramp production back up to satisfy public market fondness over production growth. This is particularly the case after capital markets opened up in 2H16 (i.e., large equity and debt issuances); E&P companies saw this as a mandate to grow.
With that said, E&Ps going forward ought to curtail growth in a sub-$50 WTI oil price environment. In 1Q17, when oil prices averaged roughly $50, more than half of the E&Ps reported EBIT losses and nearly all E&Ps reported negative free cash flow. With spot prices hovering at $43 per barrel, it is unlikely that E&Ps will continue the break-neck pace of production growth. Further, with OPEC/non-OPEC production cuts now purportedly in full swing (there are lags between production, exports, and full impact of production curtailment), global oil inventories are likely to draw over the next few months.
So, are we at an inflection point in oil prices? After all, the cure for low oil prices is “low oil prices”.
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As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.
FROM THE DESK OF LUIS AHN
Luis Ahn is a Partner and Analyst at R Squared Capital Management.
Prior to joining R Squared, Luis was a Senior Analyst at Bloom Tree Partners.
Luis received an MBA from The Wharton School and Bachelor of Science in Quantitative Economics and Computer Science from Tufts University.