Oil prices fell sharply on Monday as investors worry about demand and see supply rise faster following an OPEC deal to restore production.
Despite the decline, the current set-up appears to be able to help US shale producers as long as they don’t make the same mistakes as in the past. In fact, in recent days, analysts have become more optimistic about names like oil services company
(HAL) and producer
(OVV) even amid weakness in oil supplies.
Futures on Brent oil, the international benchmark, fell 6.1% to $69.11 a barrel, the steepest drop since March. If they close at these levels, it would mark Brent’s first time trading below $70 since May. West Texas Intermediate crude futures, the US benchmark, fell 6.4% to $67.24 a barrel, also on pace for their worst decline since March.
Oil has risen throughout the year as the vaccine rollout has slowed the spread of Covid-19 across much of the world and demand has recovered. But the rise of the Delta variant is now worrying investors and causing stocks around the world to sink. If countries are forced to delay reopening and block international travel, oil demand is likely to fall.
As the demand picture deteriorates, supply appears poised to rise, potentially leading to an imbalance that hurts prices. On Sunday, the Organization of the Petroleum Exporting Countries and its allies agreed to gradually restore the 5.8 million barrels-a-day production that had kept countries off the market. They will restore production at about 400,000 barrels per day each month until it is fully recovered next year.
“The commodities rally is not over yet, but this is likely to be a major breakthrough,” predicts Oanda analyst Edward Moya. “The fundamentals of WTI crude are still supporting a huge move higher. It will take another month or so to shake off the growing risk aversion theme.”
The market’s bearish reaction to the OPEC deal may have been exaggerated, as the alternative would almost certainly have been worse. The deal was delayed because Saudi Arabia and the United Arab Emirates disagreed on production quotas.
The greater risk to the market had been that the two countries would split up and OPEC would not be able to stick together. In that scenario, more production could have entered the market quickly. “The deal removes the tail risk in markets, especially oil stocks, which splits the UAE from OPEC/Saudi and we have a market share war,” wrote Sankey Research’s Paul Sankey.
Under the current deal, supply remains relatively limited and OPEC maintains its grip. Saudi Arabia has shown that it wants prices to stay high and will take swift action to ensure that happens as long as OPEC can keep it together.
For oil producers, the current setup can still be profitable. Inventories of North American oil and gas producers were down 12% on Monday this month. Although they are up 50% this year, they are still 25% behind the commodity as of early 2020, notes Morgan Stanley analyst Devin McDermott. He believes there is “room for further catching up” as valuations remain 65% lower than the broader market, from a historical average of 30%. For a decade, producers had drilled unprofitably and pursued a corporate strategy to increase production even if it hurt profits. That has changed this year. In the first quarter, the group recorded the highest free cash flow in more than ten years.
OPEC’s decision to continue to halt production in the coming months is a sign that Saudi Arabia is willing to cede some market share to US producers in exchange for higher prices, Bank of America analyst Chase Mulvehill wrote. That’s a “net positive for US shale,” wrote Mulvehill, who recommended investors buy Halliburton to cash in on the dynamic. Halliburton is the largest oil services company in US shale fields and would benefit from more drilling and better prices. Mulvehill also upgraded
(NOV), an oil equipment supplier.
Morgan Stanley’s McDermott also picked several stocks to capitalize on current trends. He loves
(FANG) and Ovintiv. Credit Suisse also raised Ovintiv to Outperform on Monday.
Among the biggest names, McDermott loves
(CVX) in the near term as the company could recover its buyback when it reports its second quarter results. In the long run, he likes
(XOM), citing the “excessive rate of change of cash flow relative to peers.”
The question now is whether US companies can take advantage of higher prices without making the same mistakes they made before — namely expanding into areas that aren’t as profitable to make a quick buck. Major oil companies will release their earnings reports and hold conference calls next week. Citigroup analyst Scott Gruber says he will be looking for a change in tone from the major oil producers, as well as key shale producers such as
“If the majors pursue a similar growth rate of about 5%, then we think little will change,” he wrote. “However, Exxon and Chevron have longer-term growth targets for the Permian in the mid-teens that should be monitored as a shift in this direction could impact public E&P strategy.”
Write to Avi Salzman at firstname.lastname@example.org