Oil Producers Suffer as Prices Fail to Rally

Several Rivkin members have recently asked about the prospects of Santos (STO) in the longer term as the share price in the short term has not been performing well. Broadly speaking, the STO share price will be dictated to a large degree by the price of oil and natural gas. The oil market has frequently been in the headlines recently as OPEC struggles to regain control over the price.

OPEC's power over the oil price may now have passed its peak. Despite also roping in Russia, one of the world's top three oil producers but not a member of OPEC, into an agreement to cut production, OPEC has been unable to get the price back to a level it is comfortable with. Saudi Arabia is also a top three producer (the third being the US), but unlike the other two, Saudi Arabia's economy is almost entirely dependent on oil. After over 50 years of oil production, Saudi Arabia has had no need to diversify its economy as oil has provided enough wealth to sustain a relatively prosperous nation and allowed the ruling Royal Family to keep the citizenry satisfied. The fall in oil prices in 2015, therefore, was a significant blow to the country's finances. Saudi Arabia started running substantial fiscal deficits and accumulating debt to make up the shortfall. Thinking that it could withstand the low prices for long enough to drive US shale producers out of business, Saudi initially did nothing in response. Unfortunately for them, the US producers proved to be far more resilient than expected with most US shale producers managing to reduce their cost base substantially and lower their per barrel costs. At this point, Saudi realised that it needed to do something about the low prices and so it started gathering support for an output cut from other OPEC producers. OPEC production currently represents approximately 30% of global oil production so there is still the potential for OPEC to significantly impact the market however Saudi realised that if it could also get Russia on board, it would effectively have an agreement covering approximately 40% of world oil production. Despite substantial market scepticism, Saudi was able to pull off an agreement which came into effect on the first day of this year.

The need for production cuts is no better highlighted than in the oil inventory data. The US Department of Energy published weekly oil inventory data covering a number of categories and locations. Chart 1, below, shows the progression of stockpiles since 2015.

Source: US Department of Energy

The rapid rise in stockpiles in 2015 explains why the price dropped so substantially at that time. Since then there has been some choppiness but the general trend is definitely up. This is the problem for companies like Santos, without a sustained reduction in stockpiles, it is unlikely that the oil price will gain significant ground from current prices. The good news for oil producers is that the past three months of data show that inventories are starting to reduce. OPEC has agreed to extend the production cuts until March of next year and oil bulls will therefore be hoping that this trend in stockpiles will continue until then. The risk is that inventories will start to increase again as they did in October of 2016.

The most recent headache for Saudi is the resumption of oil production growth in Libya and Nigeria. Both of these countries were exempted from the OPEC cuts (despite being members) as a result of them both being impacted by civil war. The fighting in both of these countries crippled their oil production and production cuts would therefore not be fair on these nations. With a fragile peace existing in these countries for the time being, oil production has rapidly recovered back towards pre-war levels. This production growth has offset some of the cuts by other OPEC nations and threatens to offset even more as output growth continues.

For Australian oil producers, like Santos, Oil Search (OSH) and Woodside Petroleum (WPL), the low oil prices are impacting their profitability. Further falls in the oil price would be particularly detrimental to STO which is still carrying a fairly high debt load. On the other hand, the low prices are discouraging investment and exploration in the oil sector which may be setting the market up for a future shock as supply fails to keep pace with demand. The outlook for oil is extremely complex with the rate of production growth dependent on innumerable factors and demand growth a similarly complex issue. Some are predicting demand to fall as energy efficiency and a shift towards pure electric vehicles will crimp gasoline (and therefore oil) demand.

My view is that low capital and exploration expenditure will come back to bite the oil market within the next few years as supply will fail to keep pace with demand. Therefore, I have a long term bullish view on the sector and on oil companies in general although I recognise that there could be significant volatility in the short term including further downside potential for the oil price.