The FTSE 100 finished strong last year, gaining 5 per cent in December to bring full-year returns to 12 per cent — and cheering up UK investors in the process [i]. One big contributor was energy shares, which spent most of 2017 in the red before a strong fourth-quarter rally. In the UK and globally, investors seem enthusiastic over higher oil prices and are welcoming the arrival of a potential turnaround for energy shares. However, we see a few reasons why this optimism is likely to be premature.
At $69 per barrel as of 11 January, Brent crude oil prices are at their highest since 2014 and more than double January 2016’s low [ii]. They are also up 34 per cent since 30 November 2016, when OPEC, Russia and other oil-exporting nations agreed to cut output in an attempt to address the global supply glut and put a floor under oil prices [iii] Meanwhile, global energy earnings grew triple digits last year, creating the impression that OPEC et al were successful: production down, prices up, firms profitable again.
Yet equity markets are forward-looking. Whether energy’s rally continues depends on how the oil industry’s fundamentals evolve from here. If global supply rises, oil prices will likely encounter renewed pressure, truncating last year’s energy earnings bounce, which was more a function of a low base effect than anything else. Energy earnings were high compared with 2016, but they remained well below levels seen before oil prices crashed. Once that favourable comparison is out of the year-over-year calculation, absent a sustained increase in oil prices, energy firms could have trouble surpassing investors’ high expectations for them.
Based on our analysis of oil production, it is difficult to envisage prices soaring in the near future. While OPEC did cut production, rising US supplies offset much of this. America’s current weekly production is now flirting with 10 million barrels per day (bpd), closing in on early 1970s’ record highs. The factors driving last year’s American surge remain in place. The technological revolution that powered shale continues advancing, making it easier and cheaper to extract previously hard-to-get oil. Although the IMF estimates Saudi producers require oil at $70 per barrel to break even, the average break-even oil price in US shale fields is below $40 per barrel, according to the World Bank — a 42 per cent drop since 2013. This raises profitability per well drilled at today’s prices, providing incentives to continue drilling. Many producers have locked in today’s prices with future contracts, which argues against plans to cut back. Rather, investment in exploration and new drilling rose last year, investments firms are likely keen to begin recouping. Add in the 36.1 per cent increase in drilled-but-uncompleted wells since November 2016, and it should be quite easy for US production to rise [iv].
While global output is still down since 16 November, OPEC and its partners have fallen short of their goals. Collective production averaged 52.2 million barrels per day through November 2017, missing their target by half a million barrels. Plus, their agreement expires soon, so global oil supply depends partly on whether the participating nations agree to extend these cuts. We don’t speculate about diplomatic decisions, which aren’t a market function, but consider: Russia has strong motivations to ramp up production and boost state revenues ahead of this year’s election. Moreover, when OPEC et al cut back last year, the US gained significant market share, which could further incentivise other oil-exporting nations to drill more in order to compete. The unrest in Iran provides further motivation for Tehran, with the populace upset that they haven’t benefited from the lifting of sanctions and resumption of oil exports since 2015’s nuclear agreement. Anything is possible, but the incentives seem to favour higher global production.
Everything has its day in the sun as well as the rain. One day, the energy sector will shine again. But we expect it will take longer than most seem to believe. Commodity cycles are long and slow. New projects have lengthy lead times — often years — making it easy to overshoot without realising, creating long supply gluts. The cutback process is similarly slow due to all the sunk costs involved with new projects. As long as investors fail to appreciate this, instead expecting every OPEC agreement to have a massive effect, energy’s time is likely to remain further out than most believe.
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[i] Source: FactSet, as of 11/1/2018. FTSE 100 total return, 30/11/2017 – 31/12/2017 and 31/12/2016 – 31/12/2016.
[ii] Source: FactSet, as of 11/1/2018.
[iii] Source: FactSet, as of 11/1/2018. Brent crude oil price, 30/11/2016 – 11/1/2018.
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[iv] Source: US Energy Information Administration, as of 26/12/2017.