Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Owning oil stocks ahead of Friday’s OPEC meeting is an act of faith on two counts. First, you must hope that the oil cartel might suddenly shift tack and limit oil production. Second, you must believe that, even if OPEC doesn’t cut production, oil is so low already that E&P share prices can’t go much lower. 

Neither article of faith holds up to scrutiny. Yet belief in the staying power of exploration and production stocks endures. Over the past month, crude-oil futures have declined by almost another 10 percent, while E&P stocks -- as represented by the S&P 1500 Supercomposite subindex -- have held up pretty well, down less than 2 percent.

No Worries
E&P stocks have held up even as oil kept falling this month.
Source: Bloomberg

Wind the clock back one year, and take a look at the same chart, showing the one-month performance four days out from the OPEC meeting at Thanksgiving in 2014. Looks somewhat familiar, no?

The Ghost of Thanksgiving Past
E&P stocks showed similar resolve ahead of that fateful OPEC meeting a year ago.
Source: Bloomberg

Of course, things have changed a lot in the past year. The oil price has fallen by about 40 percent, and the E&P sector by almost a quarter. OPEC’s push for market share that began a year ago -- a surprising shift that upended bullish assumptions -- is now viewed by many as the default policy stance. The day after OPEC’s November 2014 meeting, futures still indicated an average oil price in 2016 of around $70 a barrel, which is about 50 percent higher than what futures suggest now.

Getting the Message
It took a while for oil futures to reflect OPEC's new reality.
Source: Bloomberg

So owning E&P stocks now might seem like a pretty good deal: Lots of pain priced in already, and the potential for big gains if OPEC caves.

The latter bit of that reasoning, though, offers the biggest rationale for OPEC staying the course. In the face of greater competition in the global oil market -- and amid long-term threats to demand exemplified by today’s kickoff of climate talks in Paris -- it makes no sense for the cartel’s big players like Saudi Arabia to cut supply. This would merely offer succor to their rivals.

Hope that the downturn in oil prices would be short-lived allowed U.S. E&P firms to load up on more debt and sell more shares earlier this spring. The sector has mostly proven adept at making each dollar of extra capital count for more. In a report due to be released on Monday, Rystad Energy estimates that the number of new horizontally-drilled wells you need flowing to keep shale output flat has dropped from around 900 per month at the end of last year to around 600 now.

Absent OPEC throwing a lifeline to its rivals this Friday, the next few months are likely to show that things can get worse before they get better.

Commercial oil inventories, already at record levels in the industrialized world, look set to keep building through at least the first half of next year without some sort of dramatic move in supply or demand. That could push prices into the $30s or even the $20s. Granted, that doesn’t look as dramatic as the move from $100 to $40 seen in the past year or so. But $25 oil would still represent a drop of about 40 percent from here, and E&P balance sheets are a lot more stretched now than they were in late 2014.

Taking a longer look back at the sector’s history, you can see that, bad as things are, there is definitely room for stocks to go lower from here.

More Room Below
E&P stocks could fall further.
Source: Bloomberg

If nothing else, uncertainty about oil prices will feed uncertainty about cash flow, budgets and production guidance expected from E&P companies early in the new year. And if there is one thing that gnaws away at faith, it is uncertainty. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net