What will happen to oil prices?

We’ve had a spectacular decline in oil prices, so it’s a good idea to look to periods when such a decline has occurred. This gives us a chance to make sense of where things have been in the past, and what might be in store in the future.

Lessons from 1986

Conventional wisdom suggests that the oil price collapse of 1986 had a similar narrative. Between 1983 and 1985, oil prices had been in the range of US$30 per barrel. These prices were high enough to have driven strong non- OPEC growth.

At the time, OPEC decided to prioritize market share ahead of price stability. And, in the face of an oversupplied market, Saudi Arabia increased its own production by 1.6 million barrels per day, and the rest of OPEC’s by another one million barrels per day.

Read: Has the crude price bottomed?

The industry response was dramatic, and rippled through the supply chain. The number of U.S. rigs fell by more than half, and North Sea rig rates plunged as activity levels dropped. Major producers cut capital spending by about one quarter, while the industry focused on cost- cutting initiatives and imposed a hiatus on most exploration and appraisal activity. Oil prices collapsed to US$10 per barrel within eight months. In December 2014, Saudi oil minister Ali al-Naimi declared, “It is not in the interest of OPEC producers to cut their production, whatever the price is.” He added the cartel should stay the course and “whether it goes to $20, $40, $50, $60, it is irrelevant.”

These are chilling words for oil markets against a backdrop of an unprecedented liquidation of net long positions in speculative, non-commercial futures contracts. The market is still struggling to find a bottom at time of print. And OPEC is defiant in its pledge not to support prices.

Read: Oil prices won’t rebound soon: Conference Board

Further, most companies are cutting contract staff, pressuring service companies and looking closely at discretionary capital expenditures. Schlumberger’s recent earnings release cited industry E&P surveys, suggesting a 25% to 30% reduction in North American spending and 10% to 15% internationally—numbers which may prove optimistic. The song remains the same.

Revisiting fiscal break-evens

The relative stability of global oil prices in recent years suggests that the best determinant of the trading price was what key producers needed to balance their fiscal books. Particular focus has been placed on the requirements of the consummate swing producer, Saudi Arabia. Key players from the region have said the correct price for oil was above US$100 per barrel. This analysis is supported by a recent IMF analysis, which concluded the Saudis need US$106 per barrel in 2015 to break even. Chart 1 (this page) shows the breakeven prices for OPEC members.

If no one’s making money, what’s happening? The lack of cartel consensus at the November 27, 2014 OPEC meeting meant Saudi Arabia was not going to become the world’s swing producer, particularly at the expense of market share.

Read: There’s more to oilsands development than the price of oil

There were also rumblings of a market share war, with crosshairs squarely fixed on burgeoning U.S. shale oil. This is an expensive fight to pick. It’s rumoured the US$50-per-barrel drop in oil prices since last summer costs the Saudi government US$400 million per day in lost revenues. In a US$60-per-barrel environment, Saudi Arabia is expected to run a GDP deficit of 17% this year, and whittle away at its US$750-billion war chest. So why do this? Keeping oil prices low for a protracted period puts pressure on Russia, and on other major OPEC producers to heed demands for cuts. But there’s more to the story.

Shale, the swing producer?

In 1986, there was a surge in non-OPEC production growth driven by Prudhoe Bay in Alaska, the U.K.-Norway North Sea, and Brazil. Today, the threat to OPEC market share seems to be shale oil. In the last two years, non-OPEC producers have added about four million barrels per day, due to the tight oil technological revolution in North America. This growth outpaced global demand growth, and crimped the call on OPEC.

This fact became less evident in the tenuous supply environment of the Arab Spring aftermath. But it’s now in the foreground with rising Iraqi production, and the return of some Libyan barrels. We believe Saudi Arabia wants to create the perception that oil prices will stay low for longer. On the surface, picking a fight with the U.S. shale oil business seems a questionable battle given the enormous cost to Saudi Arabia. But in the near term, it seems to be working.

Read: Don’t avoid the energy sector

Recent rig data shows that the U.S. land rig count has seen some off the biggest weekly declines since the beginning of 2009—the most recent oil price plunge. Chart 2 (page 20) shows that current oil prices are below what most growth players in the U.S. require. Given that output from new shale wells in the first year tends to decline by about two-thirds, steep declines will undoubtedly curtail U.S. growth. However, the eventual rebound in oil prices means that the rigs will be put back to work almost immediately, especially given the short cycle time of these wells. So, the efficacy of this strategy is less clear. We need to consider the longer-term dividends of the Saudi strategy, as it’s likely to cast a shadow over the U.S. oil industry, which has used cheap credit to fund its spectacular growth.

But this may be a thing of the past if the Saudis get their way. High-yield spreads are blowing out and falling share prices have substantially impaired the industry’s cost of capital—perhaps indefinitely—irrespective of any return of higher oil prices. Also, this higher cost of capital is likely to be the yoke that burdens the growth prospects of marginal sources, like deepwater sources and oil sands.

Opportunity amid chaos

Picking a bottom for oil and energy stocks may be folly. Still, consider the outcome of past declines in oil prices. Table 1 (page 20) shows six bear markets in oil prices spanning several decades, and the subsequent 12-month stock performance.

Read: Finding value in oil stocks

Today, oil prices are below what key producers need to be in the black, and what most incremental growth projects need to meet hurdle rates. In an uncertain environment, investors should focus on energy stocks with strong underlying business fundamentals. The oil quote is down, but it will not remain so forever. The winners through this cycle are going to be companies that can demonstrate a superior cost structure, leading capital efficiencies and a depth of inventory of repeatable, low-risk development prospects. Also, investors should find companies with solid balance sheets that can make countercyclical acquisitions and access capital markets in a capital constrained industry. Good businesses always win.

CHART 1: OPEC MEMBER BREAK-EVEN OIL PRICE AND PRODUCTION TO BALANCE 2015 FISCAL BUDGETS

Sources: OPEC, IMF, TD Securities

CHART 2: U.S. OIL PLAY BREAK-EVEN ASSESSMENT

Note: Price required for 15% IRR. Futures strip for WTI crude oil as at January 12, 2015 Source: RBC Capital Markets estimates

Table 1: Oil prices during bear markets					S&P/TSX Oil & Gas E&P Index Total Return
Beginning of oil bear market	End of oil bear market	Duration of oil bear (months)	Peak oil price (US$/bbl)	Trough oil price (US$/bbl)	Return during oil bear market	Return in subsequent 12 months
Sources: Bloomberg LP, Sentry Investments
Nov 1985	Jul 1986	8	$31.72	$10.77	-25%	80%
Jul 1987	Oct 1988	15	$22.39	$12.60	-23%	33%
Oct 1990	Dec 1993	38	$40.42	$13.91	9%	-1%
Jan 1997	Dec 1998	23	$26.62	$10.72	-39%	16%
Sep 2000	Nov 2001	14	$37.20	$17.45	-3%	11%
Jul 2008	Feb 2009	7	$145.29	$33.98	-51%	48%
Average		17			-22%	31%

Jun 2014	?	?	$107.29	?	?	?