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Investment Strategy

Are You Ready for $40 Oil?

By Elliott H. Gue, on Dec. 10, 2014

On Thanksgiving, OPEC decided not to cut production quotas, despite a growing global glut of crude oil.

We doubt the pain in oil markets is over.

With OPEC unwilling to support the market in the near term by cutting output, prices will need to fall far enough that producers slow their capital spending plans and reduce the pace of supply growth.

Thanks to rapid development of North Dakota’s Bakken Shale and other prolific plays, US producers have driven supply growth over the past five years; the big question remains how far crude oil needs to fall to prompt producers to slash spending.

The International Energy Agency (IEA) estimates that only 4 percent of North American production requires oil prices above $80 per barrel; many companies can develop at least some of their acreage profitably with prices ranging between $40 and $50 per barrel.

How producers reacted to plummeting natural-gas prices provides some insight into what to expect now that the supply-demand dynamic in the oil market has loosened.

Expect producers to shift rigs from marginal basins to core acreage that offers the best internal rates of return. Some will lay down rigs, a move that should help to lower the cost of key services. Basins that face higher transportation costs to deliver their volumes to market will also face headwinds in this environment.

These shifts won’t necessarily reduce production volumes overnight, as oil and gas companies will look to offset the effect of lower prices by growing volumes. Some hedging on the part of producers will also support drilling activity while oil prices are below break-even costs.

US oil prices would need to overshoot the levels supported by prevailing supply and demand conditions to prompt producers to idle rigs and reduce capital expenditures dramatically. Weak balance sheets and higher-cost asset bases will compel some operators to scale back.

This supply response in the US and elsewhere will signal that we’re near the bottom of the commodity cycle. The question isn’t whether this will happen, but rather how long the process will take to occur.

Before the selloff ends, West Texas Intermediate crude oil could sink as low as $40 per barrel, a price point at which most US producers would be forced to curtail drilling activity.

Savvy investors will be able to buy high-quality exploration and production companies with clean balance sheets at compelling valuations. These names should be able to augment their existing resource bases with acquisitions from distressed sellers.

However, this sterling buying opportunity remains at least two quarters away. The next few months should bring some bounces in crude oil and energy stocks that will suck in the unwary—we would view these as a chance to exit weaker names.

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