OPEC takes their foot off the gas
On 30 November 2016, OPEC and Russia announced a cut of production for 6 months starting from 1 January 2017, shortly after the announcement the oil price was up over 9%. This article puts the cut in context, asks the question of why cut now, and finally looks at the implications for our equity funds.
The cut in context
The global oil market produces around 92mmbbls (million barrels) a day. Together, OPEC and Russia produce just under half (44.2mmbbls) of the global oil supply with OPEC producing 33.4mmbbls a day and Russia producing 10.8mmbbls a day. The cut in production by OPEC and Russia, of 1.2mmbbls a day, is significant in the global supply and demand equation. To put this into perspective, the cut is equivalent to a year of global oil demand growth.
Why cut now?
This is a question which still has us scratching our heads. In November 2014, OPEC stated they would no longer support the oil market by cutting production and instead let the market work. It was an effective decision. Oil prices fell sharply from over $110 a barrel in 2014 down to as low as $26 a barrel in January 2016. The move in prices caused production to be cut and the market was working hard to remove the over supply. Case in point, US onshore production has fallen around 1mmbbls a day over the past year due to lower prices (chart below). In short, the market was working.
Source: EIA, September 2016
So with the market working, why cut now?
When we look at the OPEC production chart (chart below), we can't help but notice rapidly rising production in the six months leading into the cut announcement. Perhaps, OPEC wanted to send a final message to the market about their power, before making a move?
Another possible reason of ‘why cut now?’ is in relation to the effect low oil prices were having on the OPEC and Russian economies. Take Russia for example. The mega economy declined -4% in 2015 and the Russian Rouble is down more than 50% since 2014.
Short term implications
There are two key short term implications of this cut in production:
Oil stocks rise – an obvious outcome, but in addition here is an estimate of earnings sensitivity of the large cap Australian oil stocks to a 1% move in oil.
Woodside Petroleum Santos Oil Search Origin 2018 earnings sensitivity 1.9% 4.8% 2.4% 1.6%
Clearly the move on any particular day needs to be adjusted for expectations around oil and what is priced into the different companies.
Inflation – Over the past 6 months, we have witnessed a number of inflationary events including the rise of commodities and the election of Donald Trump with a growth agenda. Inflation expectations are the highest they have been in almost two years. A rising oil price is likely to add to inflationary pressures in the economy further fuelling expectations of upward pressure on rates.
What happens from here?
As investors, we liked the fundamentals before the cut, and we like it even more after. The consistent demand growth and declining supply meant the market was re-balancing of its own accord. In fact, looking out three years, we see the oil market being tight. With OPEC cutting production, that rebalance has been brought forward by a year.
The Macquarie High Conviction Fund is exposed to oil production and the oil price through holdings in Woodside Petroleum, BHP and also Incitec Pivot which benefits from higher oil prices. In the Macquarie Australian Small Companies Fund, investors have exposure to Karoon Gas and Sundance Energy.
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