We expect oil stocks to continue to suffer

Saudi Arabia and Russia have agreed to limit their oil production to January’s levels. But only if other countries also limit their production. But this proposal faces several hurdles. So we expect most Canadian oil-related stocks to continue to suffer in 2016.

On February 16, the oil ministers of Saudi Arabia, Russia, Qatar and Venezuela met to deal with plunging oil prices. Over the past 18 months, the price of oil fell from US$115 a barrel to the mid-$20s a barrel. This has hurt Canadian oil producers and their dependents, such as oil-service stocks.

In the past, OPEC (the Organization of Petroleum Exporting Countries) cut its production to prop up oil prices. This was particularly true of Saudi Arabia, the world’s largest exporter of oil. Higher prices, however, made higher-cost production economically viable. So OPEC gradually lost market share.

Saudi Arabia changed its approach. It decided to produce as much as it can. The idea is to drive out higher-cost producers worldwide. This includes producers in Alberta’s oil sands and American producers of shale oil. But this strategy has hurt OPEC members with weak finances, such as Venezuela and Nigeria. According to The Globe & Mail, Saudi Arabia ran a US$98 billion budget deficit last year.

The proposal faces several hurdles

Saudi Arabia’s minister of petroleum and mineral resources Ali al-Naimi is quoted as saying, “We don’t want significant gyrations in prices…we want a stable oil price.” Still, it’s unwilling to act alone. Saudi Arabia and Russia, the world’s second-largest oil exporter, agreed to limit their production at January’s level. But only if other producers do their bit. Iraq is likely to agree to limit its output.

Iran plans to raise its production. That’s because it lost a lot of market share when it faced international sanctions over its atomic ambitions. It wants to restore its production before agreeing to limits.

We see problems with this proposal. First, it’s likely that some producing countries will refuse to limit their production. And not just Iran.

Second, it’s in every producing country’s interest to ‘cheat’. That is, to have other producers limit their production while not limiting your own.

Third, it can be cheaper for oil companies to work assets than to shut them down—provided that the cash flow can cover their operating costs. This is true of long-lived assets such as oil sands producers.

Fourth, too much oil was produced in January. So to ease the oil glut, a combination of two things must happen: demand for oil will have to pick up; and enough producers will have to shut down. But you don’t want this to happen to your producers.

In short, we expect most oil-related stocks to continue to suffer. If you buy, do so with strong integrated oil and gas producers such as blue chip stocks Imperial Oil (TSX─IMO) and Suncor Energy (TSX─SU). They’ll survive an industry shakeout.

 

The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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