Ryan Dressel, Investment Analyst, Brinker Capital
As of January 29, 2015, the price per barrel of West Texas Intermediate crude oil stands at $44, down just about 60% since its 52-week high in June 2014 (See chart below). For each 10% drop in oil, forecasters seemed to gawk at the possibility of further price decline, citing global demand projections, U.S. energy independence from The Organization of Petroleum Exporting Countries (OPEC), and increased consumption from emerging markets. What they omitted from their projections, however, was the impact that U.S. and Canadian production had on OPEC from a political standpoint.
OEPC has not adhered to an individual country production quota since 2011, but with oil prices around $100 per barrel in recent years, it was relatively insignificant news. These high prices actually worked against OPEC by encouraging too much competition from North America. During that time, North American energy companies were in the midst of ramping up production from shale, oil sands and other sources that were previously expensive to produce (refer to graphic below). In fact, United States domestic production has nearly doubled over the past six years. Eventually in mid-2014, global demand for oil began to lag supply, caused by weak economic growth in Asia and Europe, which sent the price of oil plummeting.
Facing pressure from these new low prices, OPEC met on November 27, 2014 to discuss curbing production in an effort to support higher price levels. Since OPEC’s production quota was abandoned, each member country was unwilling to reduce its output.
The indecisiveness at this meeting signaled some very profound conclusions to the market. First, it re-confirmed that OPEC continues to become a disorganized collection of countries, rather than an organized cartel. This is important because it implies that OPEC is no longer acting as a balancing agent in global markets, which can significantly increase volatility. The second conclusion made by the market was that Saudi Arabia is unwilling to cede its crude oil market share (12.2% of global production as of September 2014). In a bold statement made last December, Saudi Arabia’s oil minister, Ali Al-Naimi, confirmed these assumptions:
“If I reduce, what happens to my market share? The price will go up, and the Russians, the Brazilians, U.S. shale oil producers will take my share,” Al-Naimi told the Middle East Economic Survey last month. “Whether it goes down to $20 a barrel, $40 a barrel, $50 a barrel, $60 a barrel, it is irrelevant.”
The final conclusion from the November meeting was that smaller countries who depend on oil as a large part of their government revenue, cannot afford to cut production. These countries include Iran, Iraq, UAE, Venezuela and Nigeria among others. Due to the fact that Saudi Arabia’s reserves far exceed other OPEC members (See graphic below), they can afford to wait out low oil prices while others cannot.
What to Watch For:
There are many factors to watch as it relates to oil and its impact on various asset classes, interest rates, credit quality, and foreign exchange rates. The two most important factors are U.S. producer inventories and the Saudi production rate.
As of January 23, 2015, U.S. oil inventories reached their highest December levels since 1930 (383.5 million barrels). According to Bank of America Merrill Lynch, it takes U.S. shale producers 6 -12 months to react to rising or falling prices. If aggregate inventory levels remain near max capacity while the U.S. production rate falls, it would indicate that drilling projects are being cancelled and would likely have a large impact on small, highly-levered shale players. In turn, this could increase the number of defaults on energy company debt, which would have a negative impact on fixed income markets. The timing of these potential defaults could be accelerated as the foreign exchange rate of the U.S. dollar continues to rise. A stronger U.S. dollar makes it more expensive to finance debt levels. As previously mentioned, it is clear that the Saudis want to retain their market share and continue to drive out production from their competitors.
Internationally, it will be important to monitor global economic growth (especially in China and India), which affects demand. If demand stays relatively low, it will put additional pressure on smaller OPEC members to plead with the Saudis to cut production or take unprecedented actions to support their economies. Those countries may have their patience tested, as the International Energy Agency forecast an annual demand increase of just 900,000 barrels per day in their January report (unchanged from December).
Geopolitical risk is also an important factor to watch. The instability in neighboring Yemen could threaten Saudi Arabia’s production. Elsewhere, ISIS and the conflict between Ukraine and Russia add uncertainty to the global crude oil supply.
As the price of oil continues to decline, investors are attempting to take advantage. The four biggest oil exchange-traded products listed in the U.S. received a combined $1.23 billion in December, the most since May 2010, according to Bloomberg. Regardless, the market may require patience as the Saudis’ political chess game plays itself out while crude oil prices continue to decline.
The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.
 International Energy Agency, 2014
 U.S. Energy Information Administration, 2014. http://www.eia.gov/cfapps/ipdbproject/iedindex3.cfm?tid=50&pid=57&aid=1&cid=&syid=2010&eyid=2014&freq=M&unit=TBPD
 American Petroleum Institute, January 23, 2015
 Drilling, producing, and transporting oil is a very expensive process. As such, many U.S. energy producers require debt financing to fund capital investment. The total debt level of energy companies is approximately 16% of the U.S. High Yield Debt Market, which is almost four times higher than in 2004. Tudor, Pickering, Holt & Co. (TPH) has determined that at least 40 publicly held North American-focused E&Ps have reduced their 2015 capital expenditure guidance since December 8th by an average 31% from 2014 spending levels.http://www.naturalgasintel.com/articles/100977-domino-effect-of-lower-oilgas-ep-capex-now-hitting-offshore-midstream
 Oil Market Report, International Energy Agency. January 16, 2015. http://www.iea.org/newsroomandevents/news/2015/january/iea-releases-oil-market-report-for-january.html