Roberto Cominotto, Investment Director for energy equities at GAM, is convinced that a sustainable turning point in the oil market is within reach, thanks to the decline in US production.
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Is the slide in oil prices finally at an end? After falling below USD 30, the price per barrel has recovered and is now at the same level as last December. Even though further volatility is to be expected, the turning point in the oil market is at hand.
The current oil price crisis has been driven by the supply side – the surging production of US shale oil and at the same time OPEC increasing its output to full capacity. Conversely, demand growth is the strongest it has been in years. Investment cutbacks – the largest ever seen in the oil and gas industry – will inevitably lead to a supply decline. As demand growth remains solid, the oversupply should be absorbed in the second half of the year, which should be reflected in prices.
The sharp recovery of oil prices since mid-February is seen by many as a reaction to OPEC/Russia negotiations about a freeze of production volumes ahead of the Doha meeting. We disagree with this view and believe that the current oil price recovery is driven primarily by the acceleration of US oil production declines and increasing confidence in a supply/demand balance during the second half of the year. The failure of the Doha meeting was the most likely outcome given the unwillingness of Iran to participate in such a production freeze. For Saudi Arabia there was no reason to change its strategy now that they are finally successful with flooding the oil market and squeezing out higher cost producers. A freeze might have had a short term positive impact on sentiment, but wouldn’t have changed the supply/demand situation anyway since most producers won’t be able grow production significantly over the next 12 months. Saudi Arabia probably is also interested in not letting oil prices rise too fast too soon. They know that the longer oil prices stay low, the longer producers will not invest and the more the oil market will tighten in the coming years.
The key driver of a rebalancing oil market in 2016 is the decline in US production. The reaction to investment cutbacks is quicker in the US shale oil industry than for conventional oil deposits. The more than 75% decline in the number of active oil rigs in the US since mid-2014 has led to an accelerated output decline in recent weeks. This trend is set to continue over the coming months. The growth engine of global oil supply over the last six years has entered a phase of steep decline. While this development will be the key rebalancing factor in 2016, from 2017, global investment cutbacks should also start to affect conventional oil extraction globally, which could lead to a supply deficit. Since the end of 2014, approvals for new, large oil and gas projects have virtually come to a standstill. Due to the long lead times of these projects, the natural decline rates of global oil wells and continued demand growth, this could lead to a supply gap in the next couple of years. US shale oil, which represents only around 5% of global production, probably won’t be able to fill this gap. In the medium term, oil prices therefore need to rise to a level where producers will be incentivised to invest again. For the majority of global oil production this is around the USD 70 mark.
Iran and global demand worries
The lifting of sanctions in Iran and weaker global demand were often cited at the start of the year as the reasons for lower oil prices. Iran will increase output by 0.7 million barrels a day in 2016, but this should be more than offset by the decline in US output. We see no reason to believe a demand crisis is imminent. Global demand grew more strongly in 2015 than at any time since the financial crisis: At a conservative estimate, further growth of about 1 million barrels a day is expected in 2016.
Frequently, the slowdown in the Chinese economy is cited as one of the reasons why oil prices have fallen in the last year and a half. But contrary to what is generally assumed, demand for oil is not correlated to infrastructure investments, but rather to consumption. China’s oil imports remain high and have posted steady growth over recent years. This has mainly been due to the substantial rise in car purchases. Most of these cars are not replacements for older ones but are additional vehicles on Chinese roads. Moreover, China is also showing a clear trend toward favouring larger cars and SUVs.
Solar panels continue to rise
Another common fallacy is that renewable energies are less attractive because of lower oil prices. However, so far there is no evidence that low commodity prices are affecting the installation of renewable energy sources, despite the oil price crisis that has been ongoing for 18 months. Wind and solar projects have a 20–30 year life. Wind or solar farm investors accordingly base their investment decisions on their electricity price scenarios for the next 20 to 30 years. Short-term energy price fluctuations are therefore irrelevant. In addition, in many markets, electricity prices for renewable energies are fixed for about 20 years.
Renewable energy sources are gaining in importance, strongly driven by demand from China, the US, India and other emerging markets. In 2015, new solar installations increased by 25%; in 2016, they are set to rise another 20%. Renewables have evolved from a niche to a mainstream energy source. More than 50% of all new-built power generation capacity is now renewable.
Energy stocks are still attractive in this environment despite the recovery seen in the past couple of weeks. However, investors need to be selective within the energy investment universe. The major integrated oil companies are close to being fully valued currently despite running businesses which are not viable at oil prices below 60 USD. Furthermore, the decline of refining margins from record-highs in 2015 will negatively impact their earnings in the first half of 2016. Exploration and production companies offer the biggest share price upside from here, especially North American shale oil and gas producers with very low production costs. In the oil and gas service and equipment space, companies focused on the North American onshore markets will be the first to see a recovery in activity while offshore companies are unlikely to see a recovery before 2018. But the oil price recovery also offers opportunities outside the oil and gas space. Shares of industrial companies with exposure to energy infrastructure and renewable energy companies have suffered from the oil price crisis as well and should now benefit from improved investor sentiment towards energy related investments.
Roberto Cominotto , April 2016
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