Three Reasons You Should Invest In Oil Companies Despite Doha Failure

22nd Apr '16 by Edmund Shing

14 comments 19300 reads

The 17 April meeting of Opec and Russian oil ministers in Doha, Qatar ended without the long-awaited agreement to freeze crude oil output.

1. Brent crude oil price falls following Doha non-agreementinvesting.com

Apparently Saudi Arabia, by far the largest oil producer inOpec, refused to agree to freeze oil production volumes without cooperation from its regional political foe, Iran.

Unsurprisingly, the oil price has fallen back on this non-agreement announcement. But so far, at over $42 per barrel, the benchmark Brent crude oil price remains around 40% above its mid-January low of under $30 (Chart 1).

End of the road for oil companies? Don't be so quick

Many analysts have predicted that this is now the end of the road for the current rally in oil prices. But I would not be so sure. Yes, in the very short-term this will no doubt dampen investors' enthusiasm for the black gold. But we should perhaps also take account of a number of key facts.

1. World oil supply is already falling even without an agreement

2. Global supply of oil is already fallingIEA

Over the first quarter of this year, global daily oil supply was some 96.35m barrels of oil per day. This is nearly 1m barrels below the Q4 2015 average of 97.23m barrels per day. So oil supply is already falling.

This decline is largely due to falls in production outside the Opec nations, most notable from lower onshore shale oil production in the US as lower oil prices have forced oil companies to cut back on investment on new oil wells.

Even without a freeze in oil production by the Opec nations, global oil production should continue to fall further, as it is still simply not economical in most countries to drill new oil wells at the current $40-odd oil price.

2. Even Opec oil production fell in March

Interestingly, even without an agreement on freezing oil production, Opec oil production actually fell by 90,000 barrels per day in March as interruptions to oil production in Nigeria, the United Arab Emirates and Iraq more than offset increases from Iran (post-sanctions).

3. Global oil demand…

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Rusty2

22nd Apr '16

There is quite a bit of speculation that BP and RDSA will cut the dividends, so I would be banking on getting over 7%.

gus 1065

Last weekend's meeting in Doha demonstrated little other than that Saudi Arabia and Iran have irreconcilable differences on so many fronts that achieving a consensus within OPEC on the strategy to limit supply and bolster oil prices will be a long drawn out process.

The good news for the oil Bulls is that the longer there is perceived to be excess supply, the greater the number of marginal producers that will be put out of the market and the steeper and more sustained the eventual spike in the price of oil and oil related stocks will be. The OPEC meeting in June presents another chance for the main protagonists to thrash out a compromise and several commentators suggest that this was SA's main focus not Doha, but sooner or later low prices will choke off supply and those companies still standing will be in a position to make hay.

I think the markets are already anticipating this, hence the marked bounce already in many oil stocks this year from the majors like Shell through to the relative tiddlers such as Cairn Energy (LON:CNE), Ithaca Energy Inc (LON:IAE) and EnQuest (LON:ENQ). Several of these are already more than 100% up on their 2016 lows, although I agree with you that for many there is still considerable upside to come. This said, I don't think the progression will always be a smooth one and there may well be hiccups along the way.

Gus.

kenobi

These big players in the middle east are not acting rationally. The Saudi's and Iranians are at war, not direct war but proxy wars and financial wars. It would only take a small %age cut in opec production to increase price by 20, 30% or more. It makes no sense for them to sell more for such a lower price.
At some point a deal will be done, but when ? As this isn't a business decision, it's very brave to be betting on it.

The other issue is at what point Shale starts to increase again, perhaps it suits opec for shale output to fall so that they take more market share, before the price rises ? or what level might shale output cap the price ?

I imagine that shale will become the new swing producer, and the economics of shale will determine future oil prices. What that will be I don't know but I would guess below $100 , significantly so,

K

peterg

Hi K,

I'd think a "rational" price is in the $70-$80 range. However, I also think what we're seeing is also setting up more instability for the future - delays in large long lead time projects etc. I wouldn't be surprised to see oil back over $100 again at some point in the next few years - even though that may be a deviation from a rational long term price as much as current levels are.

Peter

Hi Peter,
I hope you are well, yes I agree, a rational price would be in that sort of range. I understand you rationale, but I would say it all depends on Shale. At the moment we have excess capacity, with the Saudi's claiming they can bring on line another 1M barrels a day on line in six months, the iranians no doubt something similar, and even the russians saying they want to up production.

Now some of that is posturing for the deal that will need to be done. But we can imagine that there's problably at least 1M that can easily come on stream in the next few months. Whether it will or not well that's a different issue. But what will happen is this will gradually come on the market, especially whatever the Iranians can produce. We'll see how sensible they are about it. If they dump it on the price will crash back to the 20's. If they leave it too long, (in terms of higher price), then other sources will come on line. So it leaves the investor in a bit of a pickle, re investing, there is too much supply, there's more to come on line shale wise in the US, but at what price will they deem it worth doing ? same question for the additional Opec capacity.

In the meantime, demand grew 1.8M last year and they're predicting 1.2M this year, shale production is falling, and of course everywhere has natural depletion.

The other issue, and one that Is suspect is driving the saudis partly, is where will oil demand peak ? It seems entirely possible to me that peak oil will turn out to be a peak demand rather than peak supply, now that the alternative sources have kicked the peak far into the future. An electric car will have a tiny fraction of the moving parts, and be fundamentally cheaper to make at some point in the future. In the same way as it was always obvious that lcd tvs would become much cheaper to produce than crt tvs, and now have much greater functionality.

So who wants to cut production now, and be left with tons of oil as demand falls to non transport uses ?

Things look very different to a few years ago when it appeared that $100 oil was the norm and here to stay.

K

Hi K,

I don't disagree with any of your points, but I do question how significant they will prove, over a say 5 year timespan.

Firstly, if the graphs in Edmund Shing's article are correct, which are apparently sourced from the IEA it looks as though supply in Q1 fell just below demand - which represents a quicker reversal than many had predicted. There are reasons that can be quoted for the production falls, but they are not unique. Secondly, it's very unclear how much SA and friends could increase production. We are certainly not in the situation, as we have in the past where SA has 2-2.5mmbopd behind taps. Iran is going to tak e afair bit of time to inrease much - the main thing that has changed there is that previously "illegal" exports are now "legal". There will, of course be increase now equipment and expertise can be imported, but there it will be slow.

Demand continues to rise, as you say. and I doubt that will change much. Technology may well slow demand from impossible levels (as would have occurred if the developing world had moved rapidly to western levels of car and plane use) to more modest and manageable ones, but I'd expect several years before there is any real chance of maintained falls (independent of economic cycles etc). Electric cars will reduce demand, but even if 50% of new cars sold from here were electric (which clearly isn't happening and won't for perhaps a decade) it would take years for significant falls in car oil use (and have little or no effect on plane, lorry or ship use). And that only really affects demand if the electricity is not generated from hydrocarbons.

I doubt anyone holding back oil now would have any real problem selling it, probably at above the prices we are talking, about in 10 years.

Peter

WarrantStar

I never invest in commodity producing companies (eg Oil, steel, wheat, milk) because the selling price of their product is really unpredictable. It will be affected by so many different factors eg highly variable supply & demand. The other factor at work here is that most of these companies are followed by lots of well paid analysts at big investment companies. They have much better access to the most important information than private investors could ever hope to have. So the private investors have no chance to win because the only information that they have access to is second rate and well out of date. They will generally be left well behind the curve & well out of pocket.
So the real question here is do you want to invest or do you want to gamble? I'm not a gambler.

Cuthbert C

23rd Apr '16

I think that the conceptual model of supply and demand which we use for most products and markets is not a good fit for the supply and demand of crude oil.

If we consider the supply/demand balance for agricultural commodities such as wheat or palm oil or for manufactured products such as cars or iPhones then we can consider supply and demand as two independent forces. We can visualise vast car parks full of unsold cars which result from supply exceeding demand; two year waiting lists for new Ferraris which results from demand exceeding supply. We can imagine silos full of grain or tank farms full of palm oil.

But crude oil is different. Oil occurs in geological formations which are in effect underground storage tanks provided by nature. (I'm simplifying a bit for the sake of clarity). There is absolutely no point pumping the stuff out of the natural storage tanks in the ground only to store it in man made tanks above ground. If "demand" reduces then producers simply produce less - they leave the stuff underground rather than pumping it. Supply is reduced to meet demand. Of course it is difficult to get the balance exactly right but by and large supply CANNOT exceed demand over anything but the very short term for the simple reason that there is nowhere to put the stuff. It is amusing to consider that the strategic reserves of countries such as the US are simply holes in the ground into which the US dumps oil which has just been extracted from a different hole in the ground. Net effect of doing that is zero - the oil has simply gone from one hole in the ground to a different hole in the ground - but I digress.

So look at the two primary charts provided by Edward - one showing supply and the other showing demand. These are absolutely NOT showing two independent processes - one driven by production and the other by consumption. IN REALITY THESE ARE BOTH SHOWING THE SAME THING - a moment's scrutiny shows that the graphs are almost identical. The minor differences between them result simply from
a) timing differences in the recording of transaction - oil is produced before it is consumed - sometimes production and consumption will end up being recorded in different calendar periods. A breakdown by calendar period may make it look like there is a fundamental difference when there isn't.
b) diversion of oil into or out of strategic storage will temporarily boost or suppress production or demand - but without any real change in the underlying reality

It is amusing to see the two more or less identical charts being presented with two radically different headlines.

"World Oil Supply is falling"

Global Oil Demand is growing"

It's the same chart - the headlines being attributed to it are both projections based on over-simplification.

It might perhaps be more correct to headline them something like
"FLUCTUATION IN SUPPLY AND DEMAND LESS THAN 5%. "

and arrive at conclusions such as:-
DEMAND ELASTICITY IS MARGINAL/INSIGNIFICANT

and more crucially for investors:-
FUTURE PRICE OF OIL WILL BE CAPPED BY SHALE

But those make for less resonant headlines

smallcapman

An excellent post tournesol.

Scm

25th Apr '16

I meant to add that in the case of crude oil people often talk about demand when what they really mean is consumption.

Storage capacity for crude oil is
a) relatively small compared with annual consumption
b) not being drained completely and then refilled - but rather tends to stay at more or less the same level as time passes

It follows from the above that beyond the very short term (ie days/weeks)

production = consumption

and that is why the two charts shown by Edward in his opening post are more or less identical.

I also meant to point out that in the chart of supply shown in the original post the headline says "World oil supply is already falling even without an agreement"

THE DATA SHOWN IN THE CHART DOES NOT SUPPORT THAT ASSERTION

What it shows is a clear and well established upwards trend over a long period. The most recent quarterly figure shows a small dip but a single data point cannot possibly show a change in direction. Consider the similar dip in Q2/15. After that dip, the underlying trend continued.

It is, in my opinion, extremely premature to call a change in direction of supply or demand/consumption. Both trends can be seen only by looking at periods longer than a single quarter or even a single year. Big projects in E&P take a decade or more. That's the timescale over which changes in direction will play out.

Red leader999

1st May '16

The stone age didn't end because..we ran out of stones..like wise oil?

never sell shell?

Red Leader

Maybe not, but I think the Paleolithic came to an end because we fell out with our Pals……..

:~)

Three reasons you should invest in Oil companies despite Doha failure

End of the road for oil companies? Don't be so quick

1. World oil supply is already falling even without an agreement

2. Even Opec oil production fell in March

3. Global oil demand…

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Edmund Shing

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