Thought for the Day: Be Wary of Oil October 2016

482538183Marco Pirondini is Head of Equities, US and Portfolio Manager of global equity strategies.

Energy investors are focused on OPEC’s recent pledge to curb oil production, which triggered wide swings in oil prices and expectations of higher prices ahead. But we’re wary of the oil outlook. The market is oversupplied, with inventories close to all-time highs for both oil and refined products. OPEC recently surprised the market with an announcement that it has brokered a deal to cut about 800,000 barrels a day. For context, production has risen from under 30 million barrels a day at the end of 2013 to almost 34 million barrels a day as of 9/30/16. Will 800,000 barrels a day make a difference?

The Devil Is In the Details

Two countries exempted from the deal, Libya and Nigeria, may increase oil production and wipe out the effects of OPEC’s cuts—if they occur. Libya went from producing 1.4 million barrels a day in 2012-2013, to 340,000 as of 9/30/16. But Mustafa Sanalla, chairman of Libya’s National Oil Corporation, said recently that his country’s oil production may reach 600,000 barrels a day in October. If true, that would wipe out 75% of OPEC’s announced cut.

Libya’s Oil Production Increase Could Negate Cuts

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Source: Bloomberg. Last data point 9/30/16; monthly data from Bloomberg OPEC Crude Oil Production Output. Data/Libya.

What about Nigeria? Production collapsed by 600,000 barrels a day in the past 6 months due to civil unrest. Oil exports are restarting as we write. A rebound of activity to normal levels of two million barrels a day would further offset the OPEC cut.

Further complicating the production picture is Iran, whose ambition is to bring oil production levels back to the pre-sanctions level of four million barrels a day.

I believe OPEC’s cut is very suspect. It seems more designed to allow Libya and Nigeria to normalize their production without creating further imbalance rather than really reducing anything. I expect oil prices will not continue to spike up as we have recently seen. Prices will more likely grind higher with a lot of false starts rather than a spike. Nevertheless, it is an important signal that OPEC has changed, and from here on they will fight to keep prices over $45 per barrel.

This will be tough for two reasons:

  • The first is excess supply. Too many providers have costs of production below $50 per barrel, and OPEC underestimates the power of free market capitalism to further reduce costs.
  • The second is low financing costs. Energy companies are taking advantage of low financing costs and new technology to innovate and lower the costs of production below $50. Low interest rate financing allows firms to recapitalize and restructure newly competitive businesses.

The bottom line: production has suffered, but has not fallen sharply. The drop in oil prices did not crush the oil industry. Prices will probably start to stabilize soon.

Even production costs for shale oil, one of the most expensive forms of oil, are dropping. US shale oil costs are below $50 in many cases. The sharp drop in oil prices had the potential to crush US shale production. The theory was that, because they are a high cost producer, they would all go bankrupt. But, as my daughter would say: Epic Fail! Some of our analysts think US shale production costs could approach $20 over time.

Oil Production Has Suffered, but Not Fallen Sharply

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Source: Bloomberg. Last data point 9/30/16; monthly data from Bloomberg US DOE Crude Oil Total Production Data.

The Future of Oil Demand?

Enough about oil supply. There is too much of it, and technological improvements may make any control of production level more difficult, not less.

Now to the second point. Does all this focus on the oil supply even matter? Energy specialists clearly think so, judging by their work. I think this is a mistake. Oil fundamentally has one primary purpose: to move our cars in the era of combustion engines. But pollution from combustion engines is so high that their future is in jeopardy. Any retreat in the dominance of the combustion engine is a retreat for oil. I believe that retreat is imminent. Since the Volkswagen emission scandals, car companies have accelerated strategies to launch new electric vehicles (EV). Even companies that were dismissing the concept are now racing to put EV on the market as fast as they can.

This trend can’t be ignored. There is a massive acceleration in EV production and we believe the impact on oil demand may come much sooner than many expect. By 2025, oil-consuming cars could be in permanent decline. A weaker demand picture will make it increasingly difficult to maintain a balance between supply and demand, and oil prices will be very difficult for any cartel organization to artificially inflate. The governor of the Bank of England has been warning pension plans to think about the long-term implication of these changes on the value of the oil reserves booked on oil company balance sheets. For oil investors, tough times are ahead.

About Marco Pirondini

Marco Pirondini is Executive Vice President, Head of Equities, U.S. for Pioneer Investments. Marco also oversees the Fundamental Research Department and is Portfolio Manager of Pioneer International Value Fund and Pioneer Global Equity Fund. He joined Pioneer Investments in 1999.
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