Stephen Bailey

Where next for Opec?

Stephen Bailey

Opec has backed itself into a corner as it looks to prolong production cuts ahead of Saudi Arabia’s mooted IPO of Aramco, the state-owned operator. Whether it succeeds in propping up prices or decides to ramp up production to inflict pain on higher-cost competitors, the key takeaway for us is this: it is Opec that will dictate the oil supply-side, leaving the UK majors as impotent price-takers.

Opec cuts at the end of last year had a short-term effect in boosting spot oil prices, but this uplift has only served to encourage more US supply back online, which is to the detriment of the Opec members. We expect Opec to extend its production cuts this year, but we would question the rationale as this essentially gives the green light on production to US operators. Data compiled by Baker Hughes, the oilfield services company, suggest that US operators have added rigs every week this year apart from one, taking the total to 697, up from 332 a year ago and the highest since April 2015.

Baker Hughes United States Crude Oil Rotary Rig Count

Baker Hughes United States Crude Oil Rotary Rig Count

Source: Baker Hughes, Bloomberg.

A basic understanding of game theory dictates that Opec’s restrictions will be hard to sustain in the medium term. While oligopoly conditions and inelastic demand imply it is in oil producer’s interest to co-ordinate production restrictions to prop up prices, in reality the temptation for producers to be non-compliant and ramp up production is too high. For a number of Opec members, internal budgetary requirements may dictate that above-quota levels of production are required in order to provide the cash flows they need. Given the knowledge that other participants may not comply – undermining any production limit – others will also be tempted to renege on production quota agreements, compounding the difficulty that Opec will have in enforcing its quotas.

The chart below, taken from Goldman Sachs and the Wall Street Journal (as at December 2016), illustrates the long-term historic tendency for Opec members to exceed their production quotas:

34 million barrels a day

While Opec’s current efforts to restrict supply have had some positive short-term effect on oil prices, it is non-Opec members that have been the main beneficiaries. We believe the cartel has fundamentally underestimated the renaissance of the US shale industry that would result from stabilising prices.

It will be increasingly hard for Opec to keep its members in line with the production restrictions. However, if Opec decides to revert to its previous strategy of allowing free production, driving oil prices down to levels where higher-cost producers would be squeezed, this would undermine the planned IPO of Saudi Aramco and the eye watering $2tn valuation which has been suggested.

Whether Opec opts to stick or twist with respect to production restrictions, it is clear that the power lies with them, and not the listed oil majors, who continue to have no means to influence the oil price.

In a blog in August of last year we stated: “The level varies between companies, but in broad terms the oil majors require an oil price of $50-$60/barrel to maintain current dividend payouts, capex commitments and high levels of gearing. Below this level, cash flow is insufficient to support, let alone progress dividends and alternative sources of funding are required. The upshot is a hand-to-mouth dividend policy funded by asset sales.” A prominent UK equity income fund manager has since referred to this policy as one of the UK majors “liquidating themselves”.

Nine months on and our assessment remains true. The chart below illustrated the current oil price against the oil price assumptions being used by the majors in their investment decisions. This clearly illustrates that the majors’ expectations are bordering on delusional.

2017 and medium-term oil price assumptions

2017 and medium-term oil price assumptions

Source: Bloomberg, company data, Goldman Sachs Global Investment Research 21.03.17. $1.5 WTI-Brent differential used for US E&Ps.

For us, the decision to avoid ownership of the oil & gas majors is an obvious one. When we invest in a stock we need to be prepared to hold it for 5 to 10 years; companies in the oil & gas sector fail this fundamental test. The current weak macro environment for oil looks set to deteriorate further over the medium and long term as the industry faces up to the challenge of viable energy alternatives.

Finding ways of gaining positive exposure to the global evolution away from fossil fuels is less straight forward. We are assessing a number of routes to access growth areas such as electric cars, but most investable options currently involve (i) accepting other undesirable exposures or (ii) over-paying for pure plays.

Taking electric cars as our example of the former, both Johnson Matthey and Umicore have strong prospects in automotive battery technology. The rub, however, is that both are already involved in the production of catalytic converters for cars using diesel and gasoline. Strong prospective growth in electric cars, is offset by the parallel decline in demand for conventional vehicles.

Moving to the latter, US-based Tesla is a good example of a pure play electric vehicle manufacturer. While its growth prospects are excellent, it has been afforded a market capitalisation which exceeds that of Ford, despite being largely loss-making and it is clearly a non-starter for an equity income portfolio.

We will continue to apply our Macro-Thematic investment approach to the investable universe as we seek out good value ways to access the inevitable long-term growth of alternatives to fossil fuels. In the meantime we believe that better income streams are available away from the oil & gas sector.


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Thursday, May 4, 2017, 11:31 AM