A major driver behind the decline in oil price was OPEC’s decision to stop supporting the oil market and thus allow prices to fall.
This response has arisen out of their continuing market share losses to the fast-growing US shale oil producers.
The substantial drop in price has materially altered spending decisions by both US shale producers as well as the larger conventional producers.
With lower spending comes ultimately lower production.
The last few months have seen much discussion and many predictions about the direction of oil prices.
The arguments are quite clear on each side: the bulls point to lower prices leading to lower capital expenditure and therefore lower supply; while the bears claim that increased efficiency, high grading of production and lower supplier costs will allow continued production growth.
In our view, the current low prices are unsustainable, primarily based on reduced capex spending and a decline in the US rig count.
Approximately eight per cent of existing oil production needs to be replaced each year – with US shale at closer to 50 per cent decline rates – simply to stand still.
With demand for oil continuing to grow globally, albeit slowly, all signals point to further expansion of the oil market and the need for additional supply, not less.
For this reason, at Wingate we expect oil prices to recover over the next 12 months, without the need for any increased economic considerations.
On our analysis, approximately 60 to 70 per cent of shale producers’ capital expenditure is used for maintenance of production.
This coincides very well with the expectation of production growth coming to a standstill, with 2015 capex cuts ranging from 20 to 50 per cent of companies reported so far this year.
One clear indicator for future supply is looking at the number of oil rigs currently in operation.
In early December, the number of rigs hit a high of 1,931. Since then, in just two months, the number has dropped dramatically to 1,633 – a significant and unprecedented decrease.
In three to six months, we will see a noticeable impact on supply and hence prices.
As often happens with fast-moving markets such as oil, prices often overshoot in the short term and then, more slowly, reach an equilibrium.
We are seeing the shares of many high-quality oil companies pricing in a prolonged period of low oil prices, something that we don’t agree with.
This could therefore create good opportunities for investors in the current market.
However, the opportunity may not be around for long. We believe we may already have seen the bottoming of oil prices, or at least we are very close.
In most commodity markets, the supply response lags the demand response quite significantly, both up and down, because it takes time to switch on and off production.
However, this is not the case with shale oil, which has driven this increase in growth.
It has a very short production cycle, with drill rigs able to be easily decommissioned and transported. This supply side response should see the oil price stabilise over the course of 2015.
As investors in the energy sector, our preference is for businesses with good cash flows that are returning funds to investors through dividends and share buybacks.
We also look for companies that are growing their intrinsic value. This can be challenging as most organisations in this sector tend to focus on growing production as a priority, at almost any cost.
Companies such as Occidental Petroleum and Canadian Natural Resources are attractive to us for these reasons. Total SA has also been a good performer for us recently.
For investors concerned that the share prices of oil companies are still to experience falls as a result of the decline in oil prices, our view is that most of the pain has already been taken, and the falls factored in to share prices.
We remain convinced that over time, oil prices will revert to the marginal cost of production of around US$70 to $80 a barrel.
The only place left for oil prices to go is up, over the medium term. It could take six months or a year, but it will improve.
Indeed, based on the magnitude of production cuts we are witnessing in the US exploration and production sector, we believe prices may normalise faster than some in the market expect.
The Wingate Global Equity Fund retains an approximate 16 per cent weighting to the energy sector, a position that was increased during the December 2014 quarter. We are now fully invested in the space.
Chad Padowitz is chief investment officer at boutique international equities fund manager Wingate Asset Management.
