Tom Nelson and Charles Whall, portfolio managers at Investec Asset Management, explain why they believe the oil price is unlikely to stay this low for an extended period of time.
Market update: animal spirits of traders and changing Saudi behaviour
Oil prices have fallen steadily since the Opec meeting on 27 November 2014. The realisation that Saudi Arabia would not moderate production to support oil prices has let loose the animal spirits of traders who continue to sell oil aggressively. Brent crude oil is hovering at US$50 per barrel (bl), West Texas Intermediate (WTI) is in the high $40s, and energy equities continue to underperform. As a reminder, the average price of Brent oil in 2014 was $99/bl. We must not lose sight of the fact that the collapse has been in near-term prices as evident through the longer-term futures price which is currently trading at $78 today.
The Opec meeting was a significant negative surprise to us and to the rest of the market. The change in Saudi behaviour cannot be overstated, and far outweighs the demand weakness which we expect to be transitory. Saudi Arabia has decided to defend market share at the expense of price for the first time since the 1980s, which will cause oil prices to fall excessively – beyond a level which rational supply/demand economics would dictate.
Without a market moderator to smooth the supply/demand balance – a role Saudi Arabia had played skilfully for a number of years – the traders can sell oil with impunity, at least for now. Opec’s decision has changed the way oil markets will function in the short term. This new era of volatility will cause a material slowdown in spending and investment which will balance the market – and this will lead in time to an oil price overshoot to the upside. Neither scenario is helpful for major oil producers: the net effect will be less investment, at a time when the sector is already struggling to combat steeper production declines and a startling lack of exploration success.
However, reflecting on the Opec meeting, we are at least now clearer on Saudi intentions, namely to slow down supply from key non-Opec producers: US shale oil and Russia. To recap, Opec had expected non-Opec supply to increase by 1.4 million bl/day in 2015. We think this scenario is optimistic.
How low can oil go?
The rational, if unanswerable, question at the moment is ‘how low can oil prices go?’. We base our oil price analysis around the four pillars of supply, demand, marginal cost and Opec – but recognise that short-term trading momentum, driven by financial speculation, is still to the downside.
• Opec: The next meeting is scheduled for 5 June 2015, but we should not discount the possibility of an emergency meeting being convened before that date. Brent was trading at $78/bl when they met in late November. In our view, Saudi Arabia is waiting for clear evidence of a slowdown in US shale oil production, which could come towards the end of the first quarter.
• Marginal cost: At $50/bl Brent oil we are already well below the marginal supply cost, defined as the cost of pumping the last and most expensive barrel required to satisfy demand, for the industry. Spending is being reduced, projects are being delayed, and investment in the sector is falling. We estimate the marginal cost for US shale to be around $75/bl.
• Demand: 2014 was a weak demand year, but still a year of demand growth. We believe that 2015 demand will be stronger, stimulated by lower oil prices (the traditional cure for low oil prices). To reiterate, the oil price collapse has not been caused by a collapse in demand, which was only 0.5% less than estimated. Chinese strategic buying of oil – for which there is ample storage capacity – could surprise the market in 2015.
• Supply: 2015 is the most difficult year to model since 2008 due to the sharp slowdown in spending. Regarding US shale oil: we calculate that spending by US shale oil producers will fall by 30%. Most importantly, we estimate that US shale oil production growth – which has been 1 million bl/day for each of the last three years – will fall to less than 0.5 million bl/day. The challenge is pinpointing the delay between reduced drilling and reduced production. Such is the efficiency of drilling and tying-in wells, this lower spending will be evident with a drop in production growth coming towards the end of the first quarter in our view.
Outside US shale oil, 2015 is expected to be a lean year for new conventional field start-ups, as we have written before. The changing tax regime in Russia has incentivised Russian producers to boost production in December and January, but the effect of sanctions and underinvestment could pull Russian production materially lower in 2015.
Our oil price forecasts for 2015
With all of this in mind we forecast that Brent oil will average $60/$70/$80/$85/bl in the four quarters of 2015, to give a full-year average of $70-75/bl, representing 40-50% upside in the commodity price from today’s level. We model no premium for geopolitical risk but note that Saudi Arabian succession, Venezuelan debt default and Nigerian elections stand out as supply-side risks.
Overall, we are positioning the portfolio for a recovery in the oil price in 2015, as described above. We believe the sell-off has been driven by Opec’s surprise actions and we expect the equities to recover in anticipation of a move higher in the commodity price. The recovery is likely to surprise investors in its speed and scale, just as the sell-off has, and we fundamentally believe that we are approaching the bottom in terms of sentiment, investor positioning and valuation. We believe the oil price is unlikely to stay below the industry’s cash operating cost for an extended length of time.