Managers welcome ‘stabilising’ cut in oil production

Opec surprised observers last week by announcing a cut in output, having previously indicated that better enforcement of quotas would be enough to sort out excess supply. This came in spite of a current oil price in excess of the target range of $22-28 a barrel. After the announcement, the price of Brent crude jumped to $33.86 a barrel. The move was immediately condemned by US treasury secretary John Snow as “regrettable”, as it would act as a tax on consumers. But how significant or surprising is Opec’s move? And who will be the winners and losers from its actions? The two-stage cut will reduce Opec’s total oil output by 2.5 million barrels a day, or 10% of total production. It will also force those countries in breach of their quotas to cut output by 1.5 million barrels a day. The Opec energy ministers blamed dollar weakness and potentially weak demand in the summer for the cut in output. Tim Guinness, manager of the Investec GSF Global Energy fund, also points out that Iraqi oil is now coming back and increasing supply, having almost disappeared during the Gulf war, at a time when oil demand is likely to drop as a result of seasonal changes. So who benefits from keeping the oil price at these levels? It is certainly not the consumer, for whom higher oil prices act as a tax. The impact is marginal in the UK, where most of the cost of fuel is tax, but the US has historically been more directly affected. John Hatherly, head of global analysis at M&G, says: “If the oil price got up to $40 a barrel, there would be a negative impact, but not at these levels. Also, in Europe and Japan the currency is appreciating against the dollar, which will offset some of the impact. Looking at most assumptions on the price of oil, it may actually be going down. Economists are still talking about 4-5% GDP growth in the US and 3-3.5% for the UK. This is not particularly alarming.” Artemis UK Smaller Companies fund manager John Dodd believes the stability in the oil price created by the cut in output can only be a good thing. He says: “It affects bigger and longer-term issues. I can’t say it’s specifically beneficial for companies like Cairn Energy or Premier Oil, which are more driven by exploration news, but it gives companies an improved framework in which to make their investment decisions. But share prices don’t usually react to this type of news.” Guinness agrees that the commitment shown by Opec to stabilising the oil price is welcome. He says: “Opec is sending a signal to the market that it is going to manage the oil price in a proactive and intelligent way.” He believes that an examination of the oil price since 1987 shows that it is now at a realistic level in line with its long-term average. He adds that anyone predicting a return to an oil price of $18 a barrel will be “confounded”. There are, of course, certain companies that benefit from the higher oil price more than others. In general, the large integrated oil companies such as BP or Shell are less exposed to a shifting oil price. They do not suffer as much when it goes down, nor do they benefit as much when it goes up. This is because they make almost as much money from “downstream” oil activities such as refining or transporting as they do from the extraction and sale of crude oil. The real beneficiaries of a high oil price are those that are focused on extraction. Among the integrated oil majors, Exxon Mobil and Total derive more of their profits from “upstream” activities. However, it is the purer oil extraction groups that benefit most. Neptune European Opportunities fund manager Barry Norris says: “Those companies that get money from oil production will see the biggest upgrades. These are companies like Statoil in Norway and Repsol in Spain. Both are very geared to the oil price.” Guinness also points to a number of US-based companies that stand to benefit. He says: “Devon and Apache should both do well. Also, the Canadian oil sands producers should be big beneficiaries. The Canadians have spent a lot of money building these extraction facilities, so the higher the oil price, the better – these producers are very operationally geared. The emerging market companies – such as PetroChina, and Russia’s Lukoil and Gazprom – should also do well.” Companies that operate in non-Opec countries get the benefit of a high oil price without the restriction on production. This is good for places like Russia. There is also growing pressure on reserves, as demonstrated by Shell’s recent announcement that it had overstated oil reserves by 20%. A higher oil price means reserves become more attractive, benefiting reserve-rich countries like Russia. Norris believes that as the bigger companies change their longer-term assumptions about the price of oil, there will be an impact on their capital spending patterns. BP has recently moved its assumption of the average long-term oil price from $18 to $20 a barrel. Norris says: “Given that BP is a company struggling to replace existing reserves, capital expenditure is likely to go up for oil companies. This should mean a capex boom for oil services companies.” Norris points to companies such as French group Technip, which designs and constructs oil facilities, offshore rigs and drilling equipment. He believes companies that investigate the viability of oil projects should also do well in the current environment. Opec’s move, although surprising, is significant only in that it confirms the cartel’s ongoing commitment to keeping oil prices stable. It is unlikely to help the oil majors out of their recent troubles, but will help the more production-focused oil and oil services companies. The impact of the cut in production for the consumer is likely to be minimal, as it would take a hefty spike in the oil price to cause a significant dent in consumer spending patterns. Ultimately, a stable oil price is a major contributor to economic stability, and that has to be welcome.