The Organization of Petroleum Exporting Countries (OPEC) caused commotion in markets last month when it announced its decision to maintain oil production targets despite decreased demand. I believe the decision not to cut oil production is the right call in the longer term.
Had the cartel cut production, the price of oil would likely have increased dramatically and stopped its downward spiral. This would have led to market share losses for OPEC and to supply gains for the U.S. independent exploration and production (E&P) companies in areas like the Permian, Bakken and Eagle Ford oil fields. In light of today’s decision, I think the oil market is going to rebalance in good, old-fashioned “Adam Smith” style*, rather than constantly relying on OPEC to manage the price.
World oil market
I believe that we will find out rather quickly that the growth engines of non-OPEC supply – the U.S. lower 48, Canadian unconventional and deepwater offshore areas – do not make economic sense if oil prices are below US$75/barrel. As a result, supply growth will be greatly reduced and the world oil market will likely swing back into balance over the next six to 12 months, helping to stabilize prices. I believe we will also see oil companies reduce their capital expenditure budgets for the 2015 fiscal year, which should further slow supply growth. In all likelihood, this will happen fairly quickly as exploration and production (E&P) companies are slated to go to their boards for approval of these budgets in the coming weeks.
I have always said that I use a constant commodity price when valuing resources companies, which tends to focus on the marginal cost of new production. This marginal cost analysis leads us to use US$75/barrel for oil and US$3.25/thousand cubic feet for natural gas.
This decision on price hasn’t changed in my models, and, as a result of the recent volatility, we have been adding to select core holdings. Using these long-term prices, the stocks are now starting to reflect 30% to 40% discounts to their net asset value.
It is my belief that the equities are overreacting and that this is normal in times of extreme volatility. I believe the equities have a very compelling risk/reward scenario priced in at today’s market, should the commodity markets for oil rebalance in due course.
By using our discipline and approach, we have been adding some really good quality companies at discounts to their net asset values not seen in some time.
*Adam Smith was an 18th century economist and philosopher best known for his book The Wealth of Nations. He was a proponent of laissez-faire economic policies and is widely considered the father of modern economics.