With some investment banks referring to the latest cartel meeting as the 'OPECalypse', market action makes us feel like the world is drowning in crude oil. Investment sentiment is so abjectly negative that the sector feels like it is 'un-investible' for the foreseeable future; normally a bullish signal. So what has changed?
When scrutinising the fundamentals, we can see that although the market's supply/demand dynamics deteriorated, the deterioration was not unmanageable. But what was surprising was that OPEC chose not to manage it in the traditional manner (through immediate cuts). So why did we not see a cut?
Simply put, the 2014 market is approximately 1% oversupplied, which is not unmanageable in itself. For the first time in thirty years we saw non-OPEC supply growth of +1.8m barrels per day (bblpd). Anaemic demand growth (700k bblpd) has not been strong enough to support this type of growth.
For only the third time in 30 years OPEC effectively abandoned its long-standing role as a market balancer and adopted a longer term 'market share protection' strategy, no doubt worried about the pace of US onshore production growth. By not intervening and consequently sending oil prices lower, OPEC effectively went to war with US onshore shale production, deciding that the best way to protect their market share was to impact the latest budgetary round of the US onshore exploration and production (E&P) companies.
With US onshore budgets 'in session' and with the redeterminations of several 'revolvers' (the easiest and most convenient source of E&P financing) happening during Oct/Nov, OPEC would have achieved little in the way of impact on US onshore production capital spend intentions (the conduit of production growth), if they had induced a short term spike in oil prices. Consequently, OPEC [sic. Saudi], whilst calling for other oil producers to 'share the burden' of any future production cuts, issued a statement that the market will 'find its own balance'.
This is something that we believe may take six to twelve months, taking into account the recent accelerated price declines. With the prospect of a potential oversupply and a soft price hanging over them, US onshore Capex budgets will be reined in. Typically Capex has represented cash flow +20-30% levels; this will most likely fall back to cash flow neutral levels based on cash flows that will have already fallen.
The last two and a half years of extremely stable oil prices has not helped Saudi's attempt at protecting market share. The low level of oil price volatility has encouraged low cost financing and an appetite to leverage cash flows for US E&P companies. By targeting a wider oil price band ($30-40 as opposed to $15), Saudi may look to influence the perceived risk of leverage, and therefore the cost of financing, for the US onshore companies.
Saudi's actions could be extreme and short term, i.e. cut aggressively once they see evidence that US budgets have been reined in and US production growth has flattened, thereby creating an oil price rally early next year, with additional supply being added ahead of the next April round of US budgets.
However, their actions may be far more straightforward, even before OPEC resisted the cut. Next year's IEA numbers of +1.14m bblpd global demand and +1.28m bblpd of non-OPEC supply are already significantly better balanced than the current 2014 supply/demand dynamics. We can now expect the +1.28m bblpd to be revised down at today's $70/bbl oil, given it includes +0.95m bblpd from US shale. The oil price slide will also go some way to help the demand higher.
Consequently, OPEC's move may well balance the market quicker than many expect and without the need to sacrifice market share. Let's not forget that what motivates Saudi [sic. OPEC] is the volume x price calculation over the medium to long term. By driving down the short term price, they are attempting to manage the medium term price higher without sacrificing volume. Ultimately, they are not burying the oil price but sowing the seeds for a higher long term price, with slower US production growth.
