Oil Price Faces Headwinds

Oil Price Faces Headwinds

Late last year we posted a blog on oil with regard to the expected production cuts that were expected from OPEC. Although there was significant scepticism surrounding whether we would see an OPEC agreement, in November last year it announced production cuts of around 1.2 million barrels per day. Furthermore, some non-OPEC countries have also agreed to cut production, most notably Russia, which agreed to reduce output by 300,000 barrels per day. In total, the OPEC and non-OPEC cuts should amount to a reduction of 1.8 million barrels per day. To put this in context, global oil production is approximately 96 million barrels per day. The cuts therefore represent 1.87% of global supply.

This may seem like a small reduction, but in fact the oversupply of the market that has persisted for the last couple of years has been of a similar order of magnitude. Small percentage changes in supply and demand in the oil market can have a significant impact on the degree of over/under supply. The reaction of the oil price to the OPEC announcement bears this out. After the announcement, the price of WTI shot above $50 per barrel where it has remained ever since. The price got as high as $54 per barrel before scepticism around whether OPEC members would stick to their production quotas started to weigh on the market. OPEC members have a history of cheating on their production quotas and some countries have already started to show signs of non-compliance. Iraq, for example, is exporting record amounts of oil although it claims production has already been cut by 160,000 barrels per day since the beginning of January.

Aside from OPEC compliance issues, higher oil prices have already started to produce a resurgence in US shale drilling activity. As the US oil market consists exclusively of private companies, there is no single entity that can control US production. Higher prices will inevitably lead to higher shale production out of the US as oil companies take advantage of the favourable pricing.

Source: Baker Hughes

Baker Hughes publishes data weekly about the number of drilling rigs currently deployed which usually acts as a leading indicator of oil production. The chart above shows the rig count for 2016 with a clear uptrend from June onwards. Increased production out of the US may partially offset the effect of the OPEC cuts and will likely provide a cap to the oil price, at least in the short to medium term. Global oil demand continues to track higher and therefore even without OPEC help the oil market is expected to eventually rebalance.  

Investors in Australian oil producers, such as Woodside petroleum (WPL) and Santos (STO) will have benefited in the last couple of months from the run-up in oil prices; the WPL share price has risen by 13.7% since the beginning of November. Investors should, however, be aware that these stocks will have difficulty maintaining upward momentum if the oil price rally stalls. It is difficult to see WTI crude rising above $60 in the near to medium term and oil stocks should be valued accordingly. Nevertheless, I believe that the long-term fundamentals for the oil market are sound and an appropriate oil driller can make a good long term investment.

This article was written by William O'Loughlin - Local Investment Analyst, Rivkin Securities Pty Ltd. Enquiries can be made via william.oloughlin@rivkin.com.au or by phoning +612 8302 3600.       

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