French oil and gas company Total recently reduced its 2017 production forecast by more than 7 per cent as a result of spending cuts and project delays. This followed a cut of the same magnitude earlier in the year. Total is not an isolated case and other oil producers will probably have to cut their production volume targets by even larger amounts. By doing so, they are sowing the seeds of the next energy bull market.
The current oil market crisis is clearly supply driven. The emergence of shale oil technology in North America, together with a long period of oil prices above $100 per barrel have led to a massive overspending cycle. OPEC’s decision at the end of 2014 not to reduce production but instead to increase it has brought us to where we are now.
As consumers have reacted to low oil prices in most regions we have witnessed the fastest demand growth since the financial crisis, but this has not been enough to push prices higher. We need a significant supply response as well. Against the background of current spending cuts, the question is not if but when supply will fall.
The North American onshore shale oil market, with its short investment cycles, reacted very quickly to the oil price decline. Over the past 12 months, the number of active oil drilling rigs has fallen by 60 per cent. US oil production has already fallen by 500,000 barrels per day from the peak in April and could easily fall by another 1m barrels over the next 12 months.
This is in contrast to the average annual growth of 1.2m experienced over the previous three years. This will help to balance the market and a scenario of supply shortage could emerge later in 2017 when spending cuts of conventional oil producers start to take their toll.
While a lot of focus is on the US and OPEC, other producers such as Total, Exxon and Shell represent about 50 per cent of global production and should not be ignored. Their production levels have been stagnating for many years as they continue to try to rein in spending. In the current environment, they face inevitable further production cuts. In 2014 the number of final investment decisions for large projects had already fallen from an average of 23 in the previous 10 years to six.
Today’s situation is similar to the oil price crisis in the late 1990s when producers also cut back spending dramatically as a result of low oil prices, overcapacities and OPEC fighting for market share. What followed was a supply shortage that lasted for about 10 years until US shale producers spent their way into an oversupplied market.
For the next nine to 12 months oil prices are likely to stay range-bound as the market weighs the impact of falling US production, rising demand, new Iranian supply and the slowing Chinese economy. During 2016 prices should start to rise, and over the longer term oil prices need to be at about $70 for producers to generate sufficient returns to satisfy 93m barrels per day of demand.
With the peak of oil oversupply in this cycle now behind us and investment in the energy sector at record underweight levels, energy stocks offer attractive upside potential. We favour North American low-cost shale oil and gas producers over integrated and service companies. These companies are likely to benefit disproportionately from service cost reductions and efficiency gains and should emerge stronger from this crisis relative to higher-cost conventional producers.
The precipitous oil price correction hasn’t spared anyone in the energy sector, including renewable energy stocks. These companies are mostly unaffected by the low oil price environment and now offer strong upside potential.
Roberto Cominotto is investment manager at GAM.