Is a 17% decline a lot? Not for a day trade… and not for an options trade. But a 17% move on oil… in a matter of hours… is A LOT. Brent crude moved as high as $130 after the Biden administration banned Russian exports on Tuesday. A day later, it was plunging… in a hurry. What happened? A few important events surrounding OPEC (Organization of the Petroleum Exporting Countries).
First, we received news that Ukrainian President Volodymyr Zelensky is open to compromise to end the war. While Ukraine’s government refuses to cede territory to the Russian government, it has said it’s open to neutrality (like dropping its goal of joining NATO).
How OPEC Controls Oil Prices
Second, OPEC and its compatriots in the energy markets sucked the air out of the oil rally. This morning, a selloff accelerated after the United Arab Emirates (UAE) called on its members to boost oil output beyond the current pace.
OPEC’s members represent about 37% of global oil supply and roughly 16% of global natural gas output. While those numbers aren’t eye-popping, keep in mind that OPEC nations control about 80% of the proven reserves in the ground. On the supply side, OPEC is in the driver’s seat.
At the worst today, the price of Brent crude fell to almost $105 per barrel before rebounding slightly (Brent fell 11.7% by the end of the day). The call to increase output accompanied a few other factors. At a conference, Iraqi oil minister Ihsan Abdul Jabbar said his nation’s customers haven’t increased demand. That helped crude rebound from the worst of the selloff.
Given that oil is a commodity that sees its price fluctuate based on both the supply and demand side of the equation – some speculation remains that OPEC won’t artificially increase output just to address the situation in Russia and Ukraine.
In addition to this news, it’s important to note that volatility for U.S. crude decreased by about six percentage points. This suggests some reduction in global volatility and geopolitical uncertainty a day after the U.S. and the United Kingdom announced plans to bar Russian imports. In itself, the decisive action reduces volatility because it was a binary event.
What’s Next for Oil?
The oil trade is not over by a long shot. The next political question will center around producer action in the United States. As I’ve said, U.S. oil production will hit a record in 2023, with producers pumping about 12.6 million barrels per day. But the U.S. needs far more oil, given the daily demand north of 20 million barrels.
U.S. producers are looking for cover not only from the White House but also from their shareholders. Producers want the Biden administration to bless oil-and-gas production here in the United States. According to reports, they will be meeting with White House officials at a major oil conference soon.
Now, they won’t increase production unless they know that policies won’t continue to reduce incentives. Otherwise, they won’t allocate capital to new production. That political cover is also needed to allow it to justify confrontation with their shareholders. As I’ve noted, many shale producers increased their output in 2014 when WTI crude oil prices surged north of $100.
However, after they rushed to pump more oil, we witnessed a dramatic increase in domestic supply. That fueled a sharp decrease in crude prices, which led to a decline in share prices. Large shareholders – enraged by their losses – pushed for big hikes in dividends and big buybacks. That has locked up their cash flow, making it harder for them to expand their output and invest in capital expenditures.
Political cover could help shift the discussions with shareholders. As Pioneer Natural Resources CEO Scott Sheffield said this week, the U.S. energy sector could effectively double its oil output in less than two years. However, “it’s going to take cooperation with Biden, it’s going to take cooperation with our shareholders,” he said. More oil appears to be on the way. Now what?
How to Play Rising Oil Output
I’ve been asked about the trend of U.S. oil production. My view is that U.S. producers will dramatically increase output – but not some of the more common names that I’ve discussed like Devon Energy, Marathon Resources, or ConocoPhillips. I think it will spill over from the major producers like ExxonMobil or Chevron, and the MUCH smaller producers who don’t have significant capital dedicated to shareholder appeasement.
I recommend that investors look outside production – and the potential costs of expanding production (debt and capital expenditures). Instead, there’s ample opportunity in the Midstream for companies involved in the transport, storage, and shipping of oil and related products.
Based on valuation scores, Plains All American Pipeline (PAA) represents the most compelling midstream pipeline operator based on its risk-reward profile. Tomorrow, I’ll break down the company’s operations, its lofty dividend, and why focusing on the Texas oil fields is a winning strategy.