Investors in the oil & gas industry may be shaken by the recent sharp turn in the price of oil. OPEC, led by Saudi Arabia, and some non-OPEC countries, like Russia, agreed to cut production in November 2016. This led to the price of oil rebounding to $55 per barrel. The price of oil though has since fallen by as much as 20% as doubts linger about OPEC’s ability to balance supply with slowing demand. There is good reason for this doubt: the oil market continues to be increasingly oversupplied.
Over Promise, Under Deliver
Despite all the renewed talk by OPEC nations to once again cutting production, global inventories continue to rise. This is most evident by the graph below. It shows the aggregate change in global inventory (i.e. difference between supply and demand) for oil since 2012. The change in aggregate inventories began decreasing in late-2012 when demand rose faster than supply. When the change in aggregate inventory reached it lowest point in mid-2014, the price of oil peaked at $108 per barrel.
That all reversed when supply began rising faster than demand in late-2014, which caused the price of oil to drop. In fact, it dropped to $26 per barrel in 1st quarter 2016 when the change in aggregate inventories increased to 3.6 million barrels per day. The price of oil rebounded to as high as $55 per barrel, as mentioned earlier, on hopes that OPEC can rebalance demand with the agreed upon 6-month production cut.
OPEC sure looks like it may have overpromised and under delivered given global inventories have further increased since those production cuts late, last year. In 1st quarter 2017, the change in aggregate inventories increased to 4.6 million barrels per day since 2012. In other words, global inventories have increased by an additional 1.0 million barrels per day since the price of oil bottomed at $26/barrel last year.
Beware U.S. Shale Production
Furthermore, the U.S. Energy Information Administration (“EIA”) expects global inventories to continue rising over the next seven quarters (yellow bars). The EIA may best understand why there is a growing surplus in oil given it is being driven by what is happening in its backyard. Unconventional oil production in shale regions of the United States have ramped up significantly since bottoming approximately a year ago when the price of oil dropped to $26 per barrel. As shown in the graph below, almost 400 oil rigs have been added from the trough experienced about a year ago. According to investment bank Morgan Stanley, this is the strongest recovery of the last 30 years.
With the price of oil dropping to its current level of around $46 per barrel, OPEC is talking about extending its production cut. Although this could be taken as a bullish signal, I would be more inclined to take it as a signal for greater production from the U.S., Canada and Brazil in capturing greater market share. OPEC simply does not have the market share or credibility it once had in controlling the global supply or price of oil. It seems to me it would be better for oil investors to focus on the numbers (i.e. consumption, production, inventories) versus the talk & promises from OPEC. The law of supply and demand will prevail. As Warren Buffett’s mentor once said:
In the short run, the market is a voting machine but in the long run, it is a weighing machine. – Benjamin Graham
Whether or not you believe the law of supply and demand will prevail in the oil market, please consult an investment fiduciary before making any investment decisions. Should you be in search of an investment fiduciary, Meritocracy Capital Partners Inc. would welcome the opportunity to serve as your partner and adviser.
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