Coming into the third quarter 2014, it was mostly calm and quiet across financial markets as major indices continued upward largely uninterrupted through the first half of the year. That all changed as the quarter progressed and renewed worry over the stability of global economic growth weighed down investors’ appetite for risk. Stocks and commodities moved broadly lower and the global energy sector was not immune. Oil prices suffered significant near-term declines, and a myriad of companies involved in the oil market value chain saw their share prices weaken as well.
One often cited concern contributing to weakness in oil prices is the consensus view that global oil markets are oversupplied. Fueling that view is the boom in North American oil production we have seen over the past few years. Shale rock formations in places like the Bakken region of North Dakota and Appalachian Basin in the eastern U.S. have long been thought to contain large fossil fuel deposits, but producing that oil was not economically feasible prior to the big climb in prices that took place from about 2004 to 2008. Costly horizontal drilling and hydraulic fracturing techniques required to extract oil from shale rock became much more viable options to producers as oil prices shifted higher.
When thinking about the present situation in global oil supply, the fact that these newer sources of North American production were not part of the oil market equation in prior decades is an important consideration. Lately, the market has been relying on growth in shale oil production to satisfy the world’s incremental energy needs which marks a significant change in the nature of global oil supply. Production from shale oil wells can ramp-up very quickly, and following the recent strong growth in output, consensus seems to be confidently extrapolating a continued surge in North American supply well into the future. There is also a fairly consensus view that shale oil technologies will migrate to other regions of the world where fossil fuels are thought to be trapped in large underground shale rock formations.
Our view on global oil supply differs from consensus in that we believe the market under-appreciates how quickly shale oil wells reach peak production and then decline. Right now, existing North American shale oil wells are being rapidly depleted such that many new wells need to come online every year just to maintain current production levels. We believe consensus fails to recognize that North American shale oil producers are essentially running hard just to stand still. Additionally, property rights, infrastructure, and geology all give the U.S. a distinct advantage over other countries when it comes to shale oil extraction. To date, although many pundits have talked about shale production in other countries such as China, there has been no tangible movement.
Saudi Arabia is also a key component of the global supply discussion and latest oil price declines. The media has made much of Saudi Arabia’s recent decision to lower the price it charges for crude. Headlines reporting a “price war” imply that Saudi Arabia wants to gain market share in oil by reducing prices and boosting output. Consensus believes that the Saudi’s have ample spare production capacity that they can tap at will, but we disagree. After all, if there were ample spare capacity, why have Saudi Arabia’s net oil exports been largely flat over the past 15 years despite a massive increase in the number of oil drilling rigs in operation across the country? Also, why did the country not tangibly increase oil exports when crude prices rose from near $10 per barrel in the late 1990s to well over $100 per barrel in 2008?
The trend in production costs is another important consideration for supply levels. Even before the recent decline in oil prices, there was an argument that finding and developing new sources of production had become more challenging and significantly more expensive; in particular as it relates to the North American shale resources that have been the driver behind the past several years of supply growth. We believe it was becoming uneconomical for many high cost producers to continue pumping oil even before recent price declines, and that view is exacerbated given today’s prices. Our view that future supply would be tight relative to demand, spurring the need for capital spending, is stronger given recent events.
If companies start to cut production, consensus may begin to recognize that markets are not as oversupplied as investors have come to believe. All told, we believe oil prices can recover from recent lows relatively quickly under the right conditions. Over the longer-term, the increasing difficulty and costs associated with developing new sources of supply may result in exploration and production companies making big investments in capital projects geared toward locating new oil deposits. That spending represents an enormous revenue opportunity for oil service companies that provide the technology and equipment required to find and extract oil.
The recent situation in oil brings to mind an important quality of financial markets. Changing expectations is a key driver of market action in the short-run, but over the long-term, shifts in price may be traced back to fundamental factors. Oil prices are no exception. In the long-run, the commodity price will always be driven by basic forces of supply and demand. We believe the latest rout in oil and oil-related stocks is a function of shifting expectations in the short-term, not the result of a tangible change in global oil industry fundamentals. We believe fundamentals in various areas of the energy sector are sustainable and should improve over time. Therefore, at current prices the risk/reward dynamic is very attractive to us. While short-term performance of these stocks will always be subject to pronounced shifts in market expectations, we believe that investors should remain patient and focused on long-term trends in industry supply and demand.
Analysis: Manning & Napier. Sources: FactSet and Bloomberg.
Unless otherwise noted, figures are based in USD. Manning & Napier is governed under the Securities and Exchange Commission as an Investment Advisor under the Investment Advisers Act of 1940.