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Timing the Cycle

By Elliott H. Gue on Jul. 18, 2015

OPEC and Saudi Arabia haven’t wavered in their strategy, despite grumbling from some cartel members. In fact, the cartel’s overall production has increased significantly, with Saudi Arabia flowing more than 10.3 million barrels per day and most pumping far more oil than their official quotas.

The bull market’s foundation began to show visible cracks between late 2013 and mid-2014, with the surge in global oil supply trumping demand destruction as the primary disruptor.

Soaring exploration and production costs—a sign of excess investment—prompted operators to reconsider capital expenditures on some projects even though oil prices remained above $100 per barrel.

As we highlighted in the Feb. 13, 2014, issue of Energy & Income AdvisorKnowing the DrillTotal (Paris: FP, NYSE: TOT) and Royal Dutch Shell (LSE: RDSA, RDSB; NYSE: RDS A, RDS B) announced plans to reduce their spending, primarily on complex deepwater prospects that had become increasingly expensive.

Although both companies planned to continue to work on projects already under development, many new endeavors were canceled outright or delayed.

That Total and Royal Dutch Shell planned to cut capital spending while oil prices continued to levitate around $100 per barrel served as an early warning that the exploration and production industry had overheated.

Meanwhile, demand destruction and growing supply ensured that oil prices were unlikely to head higher to support capital expenditures on expensive exploration and development.

These factors prompted us to take profits on SeaDrill (NYSE: SDRL) in fall 2013 and downgrade SeaDrill and Ensco (NYSE: ESV) to a sell in February 2014. (See Knowing the Drill.) We also hedged our exposure to oil prices by adding American Airlines (NSDQ: AAL) to the Model Portfolio. (See Buying the Friendly Skies.)

By summer 2014, our concerns about growing production of light, sweet crude oil in the US and limited refining capacity to process these volumes were confirmed by a presentation at the Energy Information Administration’s annual energy conference in Washington, DC. (See Key Takeaways and Investment Ideas from the EIA Energy Conference.)

Around this time, reports that Saudi Arabia had grown increasingly unwilling to cede additional market share in the US also began to circulate.

Consistent with our outlook for oil prices to remain lower for longer, we issued timely Sell calls on Hi-Crush Partners LP (NYSE: HCLP) and Emerge Energy Services LP (NYSE: EMES) and cut a number of at-risk names to a Sell, including Pioneer Natural Resources (NYSE: PXD), National Oilwell Varco (NYSE: NOV) and the entire universe of upstream master limited partnerships

We also advocated buying stocks that stand to benefit from lower oil prices in The Demand Side Beckons.

Oil continues its process of price discovery, seeking a level that encourages demand growth and catalyzes a significant drop in supply. In the near term, this process will involve further downside in oil prices, followed by an extended stay at lower levels.

OPEC’s declining output between 2010 and 2014 helped to prolong the bull market for crude oil over this period, encouraging excess production, elevated leverage levels and an inflated cost base.

Although eliminating these excesses will take time, these bubbles didn’t inflate to the same levels as in the first half of the 1980s because Saudi Arabia didn’t rein in production to the same extent and moved relatively swiftly to retain market share, drive down oil prices and squeeze high-cost producers.

Accordingly, the resulting hangover won’t be as dramatic. Nevertheless, as we saw earlier this year, investors eager to call a bottom in oil prices and energy stocks will get burned by the myriad false dawns that occur during this discovery process.

 

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