The following commentary was originally sent to Action Alerts PLUS subscribers on April 18, 2016, at 6:14 p.m. ET.
U.S. stocks quickly reversed earlier losses from this morning as traders brushed off a sharp pre-market decline in crude prices after Sunday's highly anticipated meeting of the world's major oil producers failed to result in an agreement to freeze output.
On opening, U.S. crude prices for West Texas Intermediate (WTI) opened nearly 7% while the S&P 500 energy index (XLE) opened down 1.3%. The initial decline proved short-lived, however, with both WTI and the XLE closing down 1.45% and up +1.65%, respectively.
Let's sift through the rubble and make sense of this volatility and sharp intraday reversal in both energy prices and equity valuations. First, some context. Over the weekend, a meeting of major oil exporters in Doha, Qatar, ended without a deal to freeze production. Talks aimed at reaching the first global oil deal in 15 years fell apart last-minute after Saudi Arabia indicated it would not negotiate without the participation of Iran, which refused to attend the summit and represents the Saudis' fiercest regional rival. The hype heading into the meeting -- propagated by extensive media coverage and a gratuitously politicized backdrop -- proved exaggerated and superseded by expectations for supply/demand normalization and various interim supply disruptions.
The "Doha Debacle" illuminates the deep divides within OPEC along with the organization's diminishing influence. The fact that the market ever expected a firm resolution to emerge from Doha is shortsighted: The Saudis expressed reservations around freezing output without Iran ahead of the meeting, while anyone who expected Russia to make a pact with the Saudis to keep oil frozen at these levels was simply clueless. In reality, the Russians have no excess capacity. The Saudis do -- perhaps as much as 1 million barrels a day -- but the fact that Iran had vocally refused to stabilize production following the lifting of Western sanctions in January, along with the fact that Russia is already producing at or near record levels in recent months, suggests that neither party would be willing to cede ground.
Now that expectations for any form of substantive collaboration across the world's largest producers have been nullified, it is important to focus on the supply/demand dynamics.
First, the United States is dropping production quite quickly: from 9.6 million barrels last year to an expected 8.6 million by year-end. This is unsurprising, as production is uneconomic at or below $40-a-barrel WTI prices for more than two-thirds of U.S. shale producers. The resulting capex budget cuts, coupled with the lack of affordable financing, serves as a natural balancing mechanism for the market (in other words, shale production is being spurred by tight balance sheets, low cash flows and risk of bankruptcies). In fact, the latest U.S rig count data from Baker Hughes (BHI:NYSE), long considered a proxy for the industry, fell for the fourth consecutive week.
At the same time, the U.S. still imports a huge amount of oil into the country, to the tune of 9.4 million barrels a day. Assuming the Saudis ramp production to an incremental 1 million barrels a day, it is likely we supplant our respective drop in production with an identical amount (1 million barrels a day) of Saudi oil. Meanwhile, Iran could potentially ramp production by up to an additional 600,000 barrels a day by year-end.
While that extra 600,000 barrels may appear to move the needle, it is more than balanced by demand expectations. According to the International Energy Agency (IEA), demand is expected to increase by 1.2 million more barrels a day by year-end, more than offsetting the 600,000 uptick in production.
Another new cause of falling production involves a strike among oil workers in Kuwait over wage cut proposals, which has slashed the nation's oil production by more than half (by over 1 million barrels a day). Depending on how long the strike lasts, the impact on the market's supply/demand balance could be significant. Separately, cutbacks are taking place in the North Sea and China while budgets in oil-producing countries such as Angola, Brazil, Nigeria and Venezuela are severely strained.
From a high level, although we are hardly bullish on oil producers -- in fact, we expect a large portion of U.S. shale producers to experience severe financial stress, diminishing economic returns and downwardly revised reserve balances -- we like to pick our spots and feel comfortable owning two energy names in the Action Alerts PLUS portfolio that are best-in-class in their respective verticals: Occidental Petroleum (OXY) within the E&P side and Schlumberger (SLB) within oilfield services.
On OXY, we view the stock's 4.1% dividend yield as more than safe; the company is sitting on $4.4 billion of cash, has an annualized cash flow of $2.7 billion to $3 billion (which reflects $35-a-barrel oil) and is set to receive a $1.2 billion cash windfall from asset sales. We forecast the company will end the year with over $8 billion in cash, which more than covers its $2.8 billion capital spending program and $2.3 billion in dividends (amounting to $5 billion in capital needs).
Schlumberger (which reports results Thursday) is different from every other service company as it has the coveted ability to invest through the downturn to better position itself for a recovery in 2017. We expect the stock to outperform the broader services group amid the challenging oil environment, and are bullish long-term regardless of any interim volatility.