A sharp drop in oil prices is not good for everyone: turmoil within OPEC suggests nerves are beginning to fray, and Fitch warned about a potential contraction in US production.
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The bear market for oil has arrived. Brent crude has dropped by more than 20 percent since hitting a multiyear high in June. With it hovering at $90 per barrel, oil traders are no longer confident that oil prices have reached the bottom.
Low oil prices are great for consumers. They act as a tax cut – more money in people’s pockets can have a material effect on purchasing power, and can provide a modest boost to consumer economies.
But a sudden drop in oil prices is not good for everyone. And the latest turmoil within the oil cartel OPEC suggests that the nerves of member countries are beginning to fray. According to The Wall Street Journal, cohesion within OPEC is beginning to erode as certain countries have begun to compete against one another.
Typically, OPEC acts in concert when oil prices slide too quickly, acting collectively to cut back production in order to prop up prices. However, amid the most recent price decline, Saudi Arabia and Kuwait have unilaterally cut prices in order to maintain market share, a decision that caught some market analysts by surprise. The price cut was intended to underprice oil from the United Arab Emirates, a fellow cartel member.
Similarly, Saudi Arabia has dismissed calls from Iran to cut back production. Iran is particularly vulnerable to low oil prices. Iran’s oil exports dropped from 2.5 million barrels per day (bpd) in 2011 to 1.1 million bpd in 2013 – a 56% decline – due to western sanctions. But there is no love lost between Iran and Saudi Arabia and Iranian pleas will hold little sway with Riyadh.
With Saudi Arabia as the real driver behind OPEC policy and the only country that can have a substantial impact on oil prices in the short-term, what it decides to do is ultimately what matters. And if data from the month of September is anything to go by, Saudi Arabia is in no rush to bail out its peers. OPEC produced 30.96 million bpd on average for the month, the group’s highest rate in nearly two years.
Some of that was due to more production coming back online in Libya, but it was also a function of higher Saudi output. So far it appears Saudi Arabia is not getting weak-kneed with its production levels despite the swift decline in prices.
And it is not just Iran and other OPEC oil producers feeling the pinch. Some analysts think that Saudi Arabia may even be targeting U.S. shale companies by maintaining elevated levels of production. That is because despite the impressive achievements in the U.S. shale patch, energy and exploration companies in Texas and North Dakota have dramatically higher costs than Saudi Arabia. If Saudi Arabia can weather the low-price storm for a while, it could put some of its competitors out of business.
While we are a long way from a contraction in the U.S. shale industry, there are some signs of strain. The oil and gas rig count declined a bit in early October. According to data reported by Baker Hughes on October 3, there are 1,922 rigs in operation, a decline of nine rigs compared to the week before. While just one data point, the slowdown threatens to halt what has been a consistent increase in the rig count over the last several years. Just five years ago, the rig count was almost half of what it is today.
West Texas Intermediate (WTI) oil, the benchmark used in much of the United States, dropped below $87 per barrel on October 9. It is approaching a level that will force some companies to cut back on production. “If prices go to $80 or lower, which I think is possible, then we are going to see a reduction in drilling activity,” Ralph Eads, vice chairman and global head of energy investment banking at Jefferies LLC, told Bloomberg News in an interview. “It will be uncharted territory,” he added.
Fitch Ratings also declared $80 per barrel as a major price threshold that would prompt a contraction in U.S. shale production.
With WTI dangerously close to such a trigger point, investors should consider the possibility of avoiding companies and stocks that are tied to the U.S. shale industry. One subsector – oilfield services – will most likely take the initial hit as it is a barometer for drilling activity. Oil production companies can sit on producing assets and ride out a wave of low prices, but it will be the actual drilling service companies that will suffer in the near term should drilling slow down.
Take Halliburton, one of the most iconic oilfield services companies and one of the world’s largest. Its share price doubled from $36 per share at the beginning of 2013 to an all-time high of $74 per share in July 2014. Halliburton saw record demand for its services, which include drilling, evaluation, well construction and completion, and production. But, Halliburton’s business obviously correlates pretty heavily with the price of oil. After hitting its record high in July, Halliburton’s share price has shaved off 16% of its value. But there is a long way down, and if oil prices do not recover, Halliburton’s stock could continue downwards.
That is also true for other oilfield service companies, such as Baker Hughes Inc. Baker Hughes brings in about half of its revenue from the United States, and high cost shale drillers could be some of the first to begin to slow down the frenzied drilling pace.
But it is likely the smaller oilfield service companies that are the most vulnerable. RPC Inc. is one such company that has about one-tenth of the market capitalization of Halliburton. It provides equipment and drilling services to exploration companies, and it focuses primarily on the Rocky Mountain region, the Gulf of Mexico, and the mid-continent. Without the diversification of companies like Halliburton and Baker Hughes – which operated in dozens of countries around the world – RPC will come under enormous pressure if exploration companies decide to cut back on drilling. Other companies such as Basic Energy Services, also fall into the same category.
The whole sector has taken a hit since reaching summer highs, declining somewhere on the order of 11%. But the selloff could grow much worse if WTI prices drop to the aforementioned threshold price of around $80 per barrel. Drilling activity hasn’t yet taken a big hit, but everything will begin to slowdown if prices reach such a level.
On the other hand, there is still a bullish case for oil. The Federal Reserve is perhaps the only institution that arguably holds as much sway over oil prices as OPEC. The minutes of its September meeting suggested that the central bank is not likely to rush to raise short-term interest rates. While that will not by itself provide a boost to oil prices, the situation would be much worse if and when the Fed begins to tighten its monetary policy.
More importantly, some energy analysts argue that Saudi Arabia will not be able to hold on as oil prices slide further. Riyadh has stated that it prefers global oil prices to trade between $95 and $110 per barrel. With oil well below that range in October, there is speculation that Saudi Arabia will move at some point to cut back production.
That is the bullish case for oil prices. But in the near-term at least, the bears are winning out. By Executive Report with ISA Intel. This report is part of Oil & Energy Insider.
OPEC and other major oil suppliers are more worried than they are letting on. They need high oil prices to fund their governments. Read… Dropping Oil Prices Put These Countries at Risk