Downward Sloping Ws
At time of writing, just a few trading sessions into the year, oil is down nearly 10%, the worst start to a year ever. This has erased more than $100 billion in market cap from the 60 largest public oil & gas companies in the world. Rising geopolitical risk doesn’t even seem able to stem the slide. Tensions between Saudi Arabia and Iran escalated following the execution of a Shiite cleric. Oil managed to rise 2% after the news broke, as fears OPECs biggest producers (Saud Arabia) and soon to be production growth stalwart (Iran) could see supply disruptions from a potential conflict. However, this rally failed and selling resumed finishing the day lower.
Markets seem focused on the risks of slowing Chinese economic growth and a glut of supply ubiquitously across the globe. Despite the glut, oil production has yet to meaningfully decline as both companies and countries play the pain game, in the hopes they can outlast and in the end gain market share. Until we see meaningful production cuts, bankruptcies and consolidation we likely will not see a bottom for prices.
Companies in North America have curtailed drilling and capital expenditure plans, only deploying capital in the most profitable zones, finishing wells and leaving many disconnected from the system. However flowing barrels continue uninterrupted. So with little new production coming on line, the decline rates across all wells becomes the key factor determining when we will see a supply response in America. The market had underestimated how long it would take to see falling supply, but it is starting to take hold in various markets. The market now may be underestimating how quickly production declines.
Until production declines gain momentum, we would expect to see a downward sloping trend in the Ws recovery we have written about previously. With energy high yield bonds priced for a very high chance of default, little or no asset sales and capital markets that are largely closed to the sector, this shakeout is going to pick up speed. But even if it does, the world will still have lots of oil.
With the resiliency we have seen now 18 months or so since oil last peaked, we think that this downward sloping W pattern can easily last until the summer and potentially into 2017 before a meaningful recovery to a rationale level for oil and gas companies is seen again. With the wildcard event being a change in OPEC behavior, which there is little indication of happening anytime soon.
We continue to maintain our underweight energy exposure, taking opportunities to upgrade the quality of our energy holdings; preferring those with fortress balance sheets that will be left standing when the dust settles.
But this is history, in the coming weeks we will be blogging our thoughts and positioning as we head into 2016. This will be culminated in our Market Outlook report.
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