The Organization of Petroleum Exporting Countries (OPEC) appears to be gearing up for a price war with the United States.
OPEC confounded many market watchers (including us) by failing to agree in their meeting last Thursday to cut crude oil production. According to Reuters, OPEC intends to keep their daily ceiling production levels at 30 million barrels, which is above OPEC’s own estimates for the demand in the first half of 2015.
Saudi Arabia is intending to flood the market and force prices down further to protect their world-leading market share. This strategy is aimed at curbing U.S. shale oil expansion, which vaulted total domestic oil production from 5 million barrels a day in 2008 to over 9 million barrels today. Earlier this year, in fact, the US briefly surpassed the Saudis as the world’s leading oil producer, setting off alarm bells in Riyadh.
The Saudi strategy, while damaging to their short-term revenue outlook, may prove shrewd in the long run, as shale oil is expensive to extract because of the fracking procedures necessary to access it. Simply put, falling oil prices makes fracking less economically viable.
Oil prices continued to fall after the OPEC announcement, with the global benchmark Brent crude closing on Friday at $70.15 a barrel and WTI (West Texas Intermediate) dipping to $66.15 a barrel. These prices are closing in on the production costs of shale oil, making some of the sites unprofitable – exactly what the Saudis want.
While Saudi Arabia and a few other OPEC nations have significant cash reserves that they can use as a buffer, nations that are economically dependent on higher oil prices such as Venezuela and Iran will have difficulty holding the line. Unfortunately for those nations, they have little leverage. Since Saudi Arabia produces nearly one-third of OPEC’s total output, other members are probably going to be dragged along for the ride.
There is no further action scheduled until the next OPEC meeting in June 2015. Analysts have not formed a consensus yet on who will give first – OPEC or the U.S. shale companies.
Jason Bordoff of the Center for Global Energy Policy at Columbia University believes “we may be about to find out what the break-even cost for the U.S. oil industry really is.”
Energy consultant Philip Verleger suggests that while new drilling and exploration will be harmed, companies that have existing wells can survive Brent prices in the $50-$55 per barrel range in the short term. David Goldwyn, a former State Department Coordinator for International Energy Affairs, believes that $60 is a threshold for OPEC to “hit the panic button”.
If both are correct, U.S. firms may be okay, but there is a complicating factor – debt. According to Verleger, a large amount of the expanded U.S. oil production is driven by borrowed funds. Financing for new exploration will certainly dry up in the short term, and companies with high debt relative to their operations are in danger of going under.
Business Insider recently published graphs showing the per barrel costs of specific U.S. shale oil operations and costs of international oil projects through the year 2020. As Brent prices drop below $60, many of the U.S. shale projects are almost at cost. It seems reasonable that prices will continue to drop to around $55-$60 per barrel and flatten out there as OPEC and U.S producers escalate their standoff.
OPEC’s actions assure that cheap oil will be with us for some time now, so it’s reasonable to expect stocks that are positively impacted by cheap oil to do well in at least the first half of 2015. Any airline that can lock in its fuel contract during this time will be in excellent shape. Most consumer and manufacturing stocks should also benefit from OPEC’s moves thanks to lower transportation and energy costs.
Meanwhile, stocks related in oil production are going to be involved in a shakeout. Companies with relatively higher production costs and/or excessive debt are in trouble.
If you currently hold oil stocks, dig into the fundamentals of the company’s production costs and how much debt they hold, and decide whether to bail out or hold on assuming a prolonged period of low oil prices.
If you have enough knowledge of the oil industry and can handle the risk, you may be able to pick up oil stocks at more affordable prices. As larger, stronger companies buy up weaker ones, you could benefit if you can correctly sort out the companies that will be purchased and the ones that will go bust.
Larger, well-established oil companies are available at relatively low prices as well, but prices may not be bottoming out for several months – and you may have to hold the stock for some time to see your return.
In the long run, this may prove to be a good development for U.S. oil production, as it will force companies to be as efficient as possible with shale oil production and weed out poorly run operations. Moreover, there is a limit to how long the Saudis — and their cash-strapped OPEC partners — can endure today’s artificially low oil prices. Meanwhile, let’s enjoy the low prices at the gas pump and in our heating oil tanks – while they last.