By Duncan Goodwin, head of Global Resources, Global Resources Equity Team, Baring Asset Management
A realistic look at growth
Pessimism toward the oil sector is so widespread that the market is pricing in virtually zero growth in the price of oil or any improvement in the returns that the oil industry can deliver in the future. Money managers’ underweight exposure in the commodity is near peak levels, while short positions by physical commodity speculators are at all-time highs.
We believe this dismal assessment is overly pessimistic and that many may be overlooking one of the greatest potential opportunities in resource equities today.
This is not the first time the market has been through an oil price cycle. It has happened before and the price has not perpetually remained at crisis levels. Furthermore, forecasting no improvement in equity returns into perpetuity at lower oil prices assumes that oil companies themselves will do nothing to better their situation in response to current market conditions.
But in truth, many companies are taking action. They have been cutting costs, shelving expensive capital projects, rationalising portfolio assets and consolidating. Shell’s acquisition of BG Group is one of the more noteworthy examples. The deal, which is pending completion, will help realise cost synergies and give Shell access to a more efficient production base through BG’s assets in Brazil.
Cut costs, cut supply
We have seen oil majors implementing stricter returns criteria. Indeed, a significant number of projects with projected returns of less than 15% at a $70 per barrel (pb) price point have been shelved already. In our analysis, this should have two meaningful consequences. First, it demonstrates that returns will not stay at depressed levels. If companies cut unattractive projects and reduce costs, then corporate profitability will necessarily start to rise even at the current price of $46pb for Brent crude, all else being equal.
Second, there will be a decline in oil production forecast by companies. We estimate that future global production will fall by 5.5m to 6.0m barrels per day over the next 24-36 months. It is important to keep in mind that there is a natural decline in oil production when spending stops.
That’s because unlike, for example iron ore, where a project has a long life once mined, drilled oil wells deplete much more rapidly when pumping begins. Particularly in onshore North America.
We also have to consider the impact of the unfolding adjustment in the US onshore sector. The rig count has fallen by over half just this year to 578 rigs at present. We estimate that this will bring future global production down by an additional 1.5m barrels per day from forecast levels for next year.
In fact, we expect to see an annual decline in US onshore production in 2016, possibly by as much as 500,000 barrels per day. This marks a significant change for an oil source that acted as a determinant factor on price trends in recent years.