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Recent Events And Deeper Understanding Of Global Oil Market Suggest Continued Downward Pressure For Oil Prices

Highlights

This macroeconomic view provides the top-down perspective for our oil sector investment strategy.

 

Recent updates:

  • OPEC voted to maintain production levels.
  • U.S. oil production continues at record pace, sending stored oil to record levels as well (not to mention the fraclog we pointed out in an earlier post)
  • Iran has worked out a nuclear deal with the U.S. (and other nations)

We continue to avoid adding to this sector given the global situation except in those cases where a sustained dividend will generate income.

Research & Analysis

1) OPEC Meeting

 

Members voted to maintain current production levels at the June 5, 2015 meeting. This result, combined with increasing U.S. production means a continuation of high global supply.

 

Here’s a snapshot of OPEC member production straight from the source.

 

Source: OPEC Monthly Oil Market Report, June 2015

 

We analyzed OPEC production over the last 35 years and found two key insights: 1) production has been relatively flat for the last 10 years, and 2) the relative share of production among OPEC members has stayed fairly constant since around 1990.  There have only been minor differences in a members share of production. Recently, Iran and Libya have fallen on political issues resulting in sanctions. While only Iraq has had a significant gain in the past 15 years (Angola and Qatar have doubled production as well but off very small bases). Saudi Arabia has generally maintained its share at just under a third of total production.  

 

Which raises the question…if OPEC members are generally “towing the line” (i.e. little variation between quota and actual production), why maintain production at these high levels? The answer is likely to try and reduce U.S. production which has seen the biggest increases in the last 2-3 years. Ironically, as the world’s other major producers’ production (OPEC, Russia) has remained relatively flat the increase in U.S. production is what has driven prices down. In our view the U.S. has become the “marginal producer nation”. 

 

 

Russia’s production more than doubled since 2000 but that production increase came during a period of global excess demand. There still appears to be excess demand since 2008 however it is much less than the previous 10 years and likely much closer to an equilibrium price (the world may actually have achieved an equilibrium or even be in excess supply in 2014 as consumption for that year hasn’t been calculated by EIA yet).

 

 

As the marginal producer nation, US production will be the key driver of price changes. So far, U.S. producers are willing to keep increasing production - even though WTI is half of what it was a year ago - so meaningful and sustained WTI price increases won’t be seen until production, and to some extent storage, declines significantly.

 

 

Global production is again set to see further increases in the short-term as sanctions against Iran are lifted on an international agreement regarding their nuclear program.

 

A final note…it is puzzling to us (and others, frankly) that U.S. weekly production continues to increase even as the rig count decreases. Some believe the EIA data is incorrect. We think the EIA methodology is sound but will continue to be diligent in understanding this puzzle.

Current Strategy

Long-term Investment Strategy

  • HOLD companies with sustainable dividends, low debt/equity ratio and an appetite for hedging.

Triggers for Strategy Change

  • OPEC collectively meaningfully reduces production
  • Meaningful lower production in U.S. and/or Russia
  • Meaningful higher global consumption rates
  • Improved company income statements (generated by lower expenses)
  • Changing sustainability of dividend policy (for existing or new programs)

Categories

Type: Investment Strategy Thesis

Geography: Canada, US

Sector: Energy

Sub-sector: Oil Producers

Area(s) of Analysis: WTI, OPEC, Russia, global oil production, global oil consumption

 

 

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