Oil Prices and Energy Stocks Hit the Skids. Now What?

John Hintz, CFA®
John Hintz, CFA®

In June of this year, front month oil prices were trading for approximately $107 and energy stocks were significantly outperforming the stock market for 2014.  Now oil prices are under $80 and most energy stocks have entered into a bear market (at least 20% correction).  What happened?  A combination of two events emerged to lay the foundation for the oil price plunge.  First, economic demand (and oil demand) coming out of Europe, South America and China has been quite disappointing.  Secondly, oil shale production in the United States has emerged as a significant contributor to oil supply growth.  Thus, with oil demand disappointing and oil supply growth strong it has led to an increase in oil inventories and a significant amount of excess oil looking for a home.  This has led to a substantial fall in oil prices and a corresponding decline in energy stocks.

What happens next?  While this is a difficult question to answer, our reading of the tea leaves sees a showdown between OPEC and the United States.  Historically, when oil supply and demand would get out of balance OPEC would adjust supply to match demand and avoid sudden oil price declines.  It appears OPEC is now playing a market share game.  OPEC sees the abundance of oil production growth in the United States and it does not like to see one of its top customers now become a competitor.  If OPEC had just adjusted supply downward to make room for the shale oil production in the U.S. they would have had to concede market share.  Furthermore, the elevated prices also would have motivated the United States to further grow their shale oil reserves.  Thus, OPEC elected to allow oil prices to fall with the hope that it will slow down U.S. shale oil production.  Most oil experts estimate that U.S. shale oil production comes at a higher marginal cost than the typical OPEC barrel of oil.  In theory, the U.S. oil producers should feel the impact of lower oil prices first and have to adjust their capital spending levels and lower the projected growth of shale oil.

Oil prices have not yet hit a level that has brought about a pullback in oil drilling in the United States.  We therefore see more downside risk to oil prices and energy stocks as oil prices fall to the level that brings the needed pullback in drilling activity.  Our estimate is that we need oil prices in the $65 to $75 range to slow down shale oil drilling enough to start to balance the market.  Where could we be wrong?  OPEC budges and adjusts production downward to support oil prices.  A geopolitical event that takes significant oil production off the market could also halt the oil price decline.  Otherwise we do not think we have hit the bottom for oil prices or energy stocks.  We think OPEC is focused on maintaining long term market share and wants to see a slowdown in the production of oil coming from the United States.  In order for this to occur we need to see even lower oil prices.