4th October 2016
Duncan Goodwin, head of global resource equities, Barings, looks at the long-term implications of OPEC’s oil cutback.
OPEC cutback to benefit US shale producers
OPEC’s announcement of a plan to cut oil production by 200,000 to 700,000 barrels per day (bpd) not only caught the market by surprise, but also had the desired effect of lifting the oil price. As one broker commented, “The group will literally pocket and extra cUS$10bn in oil revenues if its rhetoric delivers a cUS$4/bbl gain in the average oil price between now and 30th November,”[i] that date being when OPEC actually discloses how the cuts will be distributed. Not bad for a days work.
Understandably, these announcements – however effective they ultimately prove to be – focus investors’ attention on the near-term supply side of the oil market. In this regard, we believe there is limited value to add. Simply put, if an OPEC supply cut is announced, the oil price goes up.
However, we believe there is value in assessing the implications for both supply and demand to the oil market in the longer term.
On the supply side, we again take a simple view. If OPEC decides to restrict the supply of crude oil to support prices in the near term – as they now seem willing to do – then that supply will be replaced by production from the next price point further up the cost curve. In this instance that is US shale oil.
So how much of the supply shortfall could US shale supply? Well, given the amount of equity and debt raised by US shale oil companies, capital is clearly not a constraint. Improvements in exploration and well technology also suggest to us that oil reserves will not be a limiting factor in the ability for US onshore oil to gain market share from OPEC. No, in our opinion the ultimate constraining factor will be oil services capacity. Not rigs, where there is sufficient capacity still available from the previous oil boom at US$140/bbl oil, but other services such as well completion services and oil drilling rig equipment.
Overall we see US onshore crude production being able to technically grow by 1m bpd annually, which should be sufficient to meet demand growth over the next several years.
In this area of the market, we have several holdings that view as best-in-class companies that have managed the oil downturn well and remain core to our strategy. In particular, this includes low-cost and well managed US shale oil companies, such as EOG, and the oil services and equipment providers focused on North America, such as Halliburton and Forum Energy Technologies. All three are in the top 10 resources strategy holdings.
Oil demand today and tomorrow
What about the demand side of the oil market? Here too, near term events may be a prelude for a significant longer-term effect on the oil market. The idea of electric vehicles moving into the mainstream has gained traction since the start of the year when we first wrote about it. The success in pre-orders for the Tesla Model 3, which saw 400,000 were ordered in the first month, has led to most mainstream automakers revising and advancing their electric vehicle strategies. We believe that the rise of electric vehicles is now a question of ‘when’ and ‘how quickly,’ rather than ‘if.’
We provide an update of our views on the investment implications of this in a forthcoming white paper. We continue to believe the most successful strategy for investment will be with those who supply materials for the electric vehicle battery industry. We believe barriers to entry for many of these materials; most notably lithium, battery separator manufacturers and cathode material suppliers are high. We have maintained or added to our investments in Albemarle, Orocobre and Galaxy Resources, for lithium. We have done the same with W-Scope and Asahi Kasei for separators and Johnson Matthey for cathode materials.
Increasing uncertainty for both supply and demand of oil make increased volatility in the oil price inevitable, in our opinion. This is unfortunate for those in the industry that look to make investment decisions based on long-term oil price assumptions, such as integrated oil companies and good for those who profit from higher price volatility, such as Dutch oil and gas logistics company Vopak.
In conclusion, while much will undoubtedly be written about the near term impact of OPEC’s decision on the oil price, we are positioning the Barings Global Resources strategy to take advantage of the longer term implications for the oil market by identifying and investing in quality companies that we believe have the best long-term prospects for growth.