Image Source: Exxon Mobil Corporation – 2019 IR Presentation
By Callum Turcan
On March 5, the Organization of Petroleum Exporting Countries (‘OPEC’) is holding an “extraordinary” meeting in Vienna, Austria (EWO), which will be followed up by a ministerial meeting between OPEC and non-OPEC members the next day. The group had already agreed to cut oil (USO, BNO) supplies by an additional 0.5 million barrels of per day (‘bpd’) back in December 2019 through an agreement that would last through March 2020 (that was on top of an existing deal to keep 1.2 million bpd off of the market which runs through the end of March 2020 as well).
As part of that deal, Saudi Arabia (KSA) offered to “voluntarily” reduce supplies by an additional 0.4 million bpd; however, that hasn’t been enough to prop up oil prices (even though ~1.7-2.1 million bpd of oil supplies are effectively removing removed from the market at 100% compliance). As of this writing, the internationally-oriented May 2020 Brent contracts are trading near $52 per barrel, down from the high $60s level seen at the end of 2019. The US-oriented WTI contracts haven’t fared any better, and April 2020 deliveries are trading near $47 per barrel as of this writing.
US Shale Just Won’t Give Up
There are several moving pieces. For starters, US (SPY) oil production grew by 11% in 2019 and surged over 12.2 million bpd according to the US Energy Information Administration (‘EIA’). That trajectory, even in the face of low raw energy resource prices (that includes oil, natural gas liquids, liquified natural gas, and natural gas), continued into 2020. By the end of February 2020, the US was producing around 13.0 million bpd on a weekly basis. We view the upstream independent space (the producers of raw energy resources) as relatively poor investments in the current environment given the “shale treadmill” (these firms must spend all of their cash flows reinvesting in the business as the annual decline rates at wells brought online via horizontal drilling and hydraulic fracturing range from ~45-80%) and there has been a call for these firms to scale back to better allow for potential free cash flows, but the industry simply hasn’t listened.
This is why the small- and mid-cap focused SPDR S&P Oil & Gas Exploration & Production ETF (XOP) has performed so poorly both year-to-date and over the past several years. Furthermore, please note that we removed the larger-cap focused Energy Select Sector SPDR ETF (XLE) from both our Best Ideas Newsletter and Dividend Growth Newsletter portfolios back in August 2019 (link here) to raise cash and exit ideas that we saw as facing serious headwinds in the near-term. We were right to do so (XLE has tumbled alongside oil prices of late), and even if the upcoming OPEC and OPEC+ (refers to both OPEC and non-OPEC members) meetings yield some sort of incremental supply reduction, that still won’t change our opinion on the matter and we aren’t looking back. There are some quality plays in the energy space, particularly as it relates to income generating opportunities, but one must be very selective here (and it goes without saying but for clarity, raw energy resource prices need to cooperate as well when to comes to capital appreciation potential).
Demand Destruction
Pivoting back to the situation OPEC+ faces, due to the ongoing novel coronavirus (‘COVID-19’) epidemic, global oil demand is expected to fall materially during the first quarter of 2020. The International Energy Agency (‘IEA’) forecasted that global demand will drop by over 0.4 million bpd during this period, a prediction made back in February. There’s more to the story here. Rising non-OPEC supplies from countries like the US have fundamentally altered global supply-demand dynamics, and effectively OPEC hasn’t been growing its oil production over the past several years in the face of material global oil demand growth (for instance, global oil demand rose by over 0.7 million bpd in 2019 according to the EIA) to make room for those additional barrels, seeding market share to shale and other non-OPEC sources of supply.
With that in mind, if global oil demand drops but supply continues to rise, this ends up flooding the market as shale players are ultimately banking on never-ending demand growth to absorb their incremental output. This is why OPEC is reportedly considering cutting another ~1.0 million bpd off the market and extending the existing supply cut agreement. It won’t be clear until after the upcoming meetings if that will include commitments from non-OPEC members as well, given that Russia (ERUS) hasn’t been keen to further cut down on supplies as the country would prefer to simply boost its own domestic output and wait out the North American shale patch (Canada (EWC) has also seen significant upstream shale development). To secure such a deal, Saudi Arabia has again reportedly offered to take on the brunt of the cuts.
It isn’t clear how long such a deal would need to last given the known unknowns and unknown unknowns regarding COVID-19. China (FXI, KWEB, MCHI) was impacted first by the epidemic, but with reported cases rising in Italy (EWI), France (EWQ), Germany (EWG), the UK (EWU), South Korea (EWY), potentially Japan (EWJ), and now the US as well, that’s a lot of potential demand destruction that couldn’t readily be cured by even deeper supply curtailments. Even if COVID-19 does get contained, that doesn’t mean that consumers won’t cut down on travel (reductions in air travel demand has been a big part of why various groups are expecting significant drops in oil demand) and part of the containment process involves workers, children (schools getting cancelled), and families staying at home (which puts tremendous downward pressure on automobile-related gasoline and diesel demand, likely resulting in further drops in global oil demand).
Other Considerations
Given that many OPEC members don’t have other meaningful ways to generate export income, raise tax revenue, or cut expenditures (two-thirds of working Saudi Arabians are employed by the state in some capacity, cutting down the size of that headcount would have serious effects on the domestic economy and state of civil affairs), OPEC is the most desperate to get a deal done. On the other hand, the Russian economy is more diversified (Russia is only major non-OPEC member willing to cut production, other non-OPEC countries like Kazakhstan (FM) pledge to cut output then historically have not delivered and actually increased output when able) and Moscow (apparently) intends on using this dynamic to its benefit. Whether that involves simply not joining on to the new agreement and banking on OPEC cutting on its own, or only agreeing to a very marginal incremental output cut (either on top of what is already in force regarding the December 2019 OPEC+ supply curtailment agreement, or simply agreeing to extending its commitment under that deal) remains to be seen.
Another factor that’s now in play is rising oil exports from Guyana, a small nation in northern South America that only recently became an oil exporter. We’ve covered that development extensively (link here), with Exxon Mobil Corporation (XOM), Hess Corporation (HES), and CNOOC Ltd (CEO) leading the charge. Supplies from Guyana are set to ramp up significantly (hitting several hundred thousand barrels of oil per day) over the coming years, short of oil prices crashing through the floor, further complicating OPEC’s efforts to prop up prices.
Concluding Thoughts
While there’s a decent chance OPEC will agree to extending and possibly deepening the cut, it isn’t clear how OPEC+ will respond without a firm commitment from Russia. Regardless of the outcome, there isn’t much the cartel can do to revive oil prices unless US oil production turns negative in a meaningful way, in our view. Demand destruction concerns regarding COVID-19 remain a known unknown and could easily offset any OPEC/OPEC+ supply reduction in a meaningful way. We’ll continue to follow this story and keep our members updated as more information becomes available.
Oil & Gas (Majors Industry) – BP CVX COP XOM RDS.A RDS.B TOT
Independent Oil & Gas Industry – APA COG CLR DVN EOG MRO OXY PXD
Industrial Minerals – ARLP, CCJ, CNX, HCR, NRP
Refining Industry – HES HFC MPC PSX VLO
Oil & Gas Pipeline Industry – ENB ET EPD KMI MMP
Related: EWO, SPY, KSA, FM, ERUS, FXI, KWEB, EWI, EWQ, EWG, EWU, EWJ, EWY, MCHI, CEO, USO, BNO, ARMCO, XLE, XOP, VDE, AMLP, AMZA
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Callum Turcan does not own shares in any of the securities mentioned above. Kinder Morgan Inc (KMI) is included in Valuentum’s simulated Dividend Growth Newsletter portfolio. BP plc (BP), Enterprise Products Partners L.P. (EPD), and Magellan Midstream Partners L.P. (MMP) are all included in Valuentum’s simulated High Yield Dividend Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.