Summary
Saudis reportedly tell U.S. shale firms they will get no “free ride.”
However, they have already given shale a free ride thanks to derivatives market and there is nothing that OPEC can do about it.
Should OPEC change tactics once again, downside in oil will be very significant.
Back at the end of February, I wrote that OPEC had little time to provide additional support for oil prices before they would fall. With too many speculators on the long side, prices had to go up or crush. The latter happened, sending Brent to $51 per barrel and WTI to $48. This was a short-term technical call. However, recent reports showed that a mighty bearish catalyst might appear on the fundamental front.
As most readers already know, senior Saudi officials reportedly told U.S. shale companies that they should not expect automatic renewal of production cuts. In other words, Saudis, who carry the biggest burden of the deal, do not want to provide additional support for U.S. shale firms. Yes, after only two months of production cuts, the biggest player seems ready to get out of the deal.
I read a lot of commentary on the news in the Internet lately. Speculations are diverse and some observers even suggest that Saudis want to talk U.S. shale into a production cut deal. I’m a big Occam fan and I don’t like to complicate things in my life unless it is really necessary.
In the case of Saudi Arabia, I believe a simple thing happened – they miscalculated their production cut move. The U.S. shale production proved to be more resilient (once again!) than they anticipated. To add insult to injury, Saudis seem to prepare for the worst thing anyone can do — leave the Plan B (Plan A was to let the market reach balance without production cuts) without giving it the time to influence the market and return to the previous scheme.
If this is really what Saudi Arabia wants to do, it is a huge bearish development and oil prices have fallen for a very good reason. Back in November 2016, OPEC had two main options. They could have let the market do its job and reach the inevitable balance (remember, U.S. oil production was falling at that time) or they could have cut production and stick to cuts unless the balance is reached. If they do not continue the production cut deal, they will effectively provide lifeline for U.S. shale and at the same time keep prices low. This is the worst possible outcome.
Judging by the fact that oil futures curve has been flat since oil prices reached the $55 whereabouts, a big chunk of hedging has been already done. So, if Saudi Arabia gets out of the production cut deal and even increases production compared to pre-deal levels, it will not be able to do material damage to U.S. shale this year. In my view, Saudis should continue the deal and patiently wait for the market to come to balance. The other option is outright bearish for oil prices and does not hurt U.S. shale in the near term.
Several classes of stocks will suffer should Saudi Arabia choose to battle U.S. shale by leaving the production cut deal. First, I believe that dividend stocks will not be immune to the downside. The likes of Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) have risen on demand for yield and became overpriced. If Fed hikes (which are already a negative catalyst for dividend stocks) get coupled together with additional downside in oil, significant downside should be expected. Also, offshore drilling stocks should see material downside (read here for a deeper discussion on the topic). At the same time, stronger shale players like Pioneer Natural Resources (NYSE:PXD) may see less downside in the near term if they did their hedging homework well.
Bottom Line
There is no surprise that oil did not immediately rebound after major downside. The risks of Saudi Arabia leaving the production cut deal after just six months are real and will have a major negative effect on the market. The U.S. shale has already gotten “free ride” for this year thanks to derivatives markets, and OPEC would be better off accepting this fact rather than trying to break shale’s back.