By Norman MacDonald, CFA
The Organization of Petroleum Exporting Countries (OPEC) recently caused ripples in the market with its decision to maintain oil production targets at current levels and not cut its output in response to weakening oil prices. I feel that this decision is the right call in the longer term.
Had the cartel cut production, the price of oil would likely have increased dramatically and stopped its downward spiral. This would have led to market-share losses from OPEC, and to supply gains coming from the US independent exploration and production (E&P) companies in areas like the Permian, Bakken and Eagle Ford oil fields. In light of OPEC’s decision, the oil market is going to rebalance in good, old-fashioned “Adam Smith” style — based on supply and demand in the free markets — rather than constantly relying on OPEC to manage the price.
It is my belief we will find out rather quickly that the growth engines of non-OPEC supply — being the US lower 48, Canadian unconventional and deepwater offshore areas — do not make economic sense with oil prices below $75 per barrel. As a result, supply growth will be greatly reduced and the world oil market will likely swing back into balance over the next six to 12 months, helping to stabilize prices. I also expect to see oil companies reduce their capital expenditure budgets for the 2015 fiscal year, which should further slow supply growth. In all likelihood, this will happen fairly quickly as E&P companies are slated to go to their boards for approval of these budgets in the coming weeks.
Turning to equities, I have always said that when valuing natural resources companies, I use a constant commodity price that tends to focus on the marginal cost of new production. In this case, marginal cost is the cost of producing one more barrel of oil. This marginal cost analysis leads me to value companies based on prices of $75 per barrel of oil and $3.25 per thousand cubic feet of natural gas. This decision on price hasn’t changed in my models, and, as a result of the volatility witnessed over the past couple of days, my strategy has been adding to select core holdings. Using these long-term prices, the stocks in my energy strategy are now starting to reflect 30% to 40% discounts to their net asset value. It is my belief that equities are overreacting and that this is normal in times of extreme volatility. Should the commodity markets for oil rebalance in due course, I believe equities have a very compelling risk-reward scenario priced in at today’s market. By using our disciplined approach, we have been adding some really good-quality companies at discounts to their net asset values not seen in some time.
Important Information
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Businesses in the energy sector may be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply-and-demand for energy resources. Short-term fluctuations in energy prices may cause price fluctuations in an energy fund’s shares.
Commodities are volatile and may not be suitable for many investors.
