The big news this past week was a massive OPEC deal that finally made good on talk about a worldwide cut in oil production. In case you missed it, the agreement resolves to remove about 2% of global oil production, with the Organization of Petroleum Exporting Countries’ member states cutting 1.2 million barrels of daily output and non-OPEC producers, including Russia, reducing 600,000 barrels daily.
That news had a big impact on the market, resulting in a roughly double-digit move for oil CLF7, +1.21% , putting prices above $ 50 again for the first time since June. And a number of smaller energy companies have exploded higher, including:
• Domestic explorer Whiting Petroleum Corp. WLL, +1.16% up 25%.
• Oil-field service company RPC Inc. RES, +2.90% up 16%.
• Deepwater driller Transocean Ltd. RIG, -0.15% up 15%.
• Refiner Sunoco L.P. SUN, +3.20% up 13%.
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However, one interesting development of the past few days has been the rather tepid response from Big Oil stocks. Even as these smaller names rallied nicely, giants like Royal Dutch Shell RDS.A, +0.27% RDS.B, +0.36% and Chevron Corp. CVX, -0.26% were only up 3% or so — and Exxon Mobil Corp. XOM, -0.23% was barely in the green with a gain of less than 1%!
So what gives?
Well, the bottom line is still the bottom line for big oil companies — and unfortunately, even a few extra bucks tacked on to a barrel of oil is not going to undo the past 10 years of pain.
Big Oil is stuck in a secular decline. And that means all investors should be wary of thinking a recovery in oil prices is a sign that oil giants like Chevron and Exxon are back.
A story of supply and demand
It’s a bit reductive, but the story of Big Oil’s troubles are all about simple supply and demand trends.
On the supply side, a global glut of oil has continued steadily for some time. According to the International Energy Agency, world oil supply has expanded from 90.4 million barrels a day in the beginning of 2013 to 97.2 million barrels a day as of the end of the third quarter of 2016. That’s an 8% expansion in just three years, and occurring even as oil prices crashed from about $ 90 a barrel to current “highs” around $ 50.
It’s important to remember that a big reason for this surge in supply is the emergence of the United States as a global energy superpower, taking the top spot in global oil production in 2014 and only recently ceding it to Saudi Arabia. The surge in U.S. production over the last decade is simply amazing, from just under 5.1 million barrels a day in 2006 to 9.4 million in 2015 — a surge of 84%!
It’s not just the percentage increase that matters, either. As you’ll recall from the OPEC deal, oil-producing nations are agreeing to a collective cut of 1.8 million barrels per day. While that’s certainly substantive, it’s also about a fifth of U.S. oil output — which, if past is precedent, will only continue its upward trajectory.
That’s because shale-oil frackers have been resilient even in the face of falling oil prices, cutting costs and pumping frantically so they can sell enough crude to keep the lights on. As the Wall Street Journal noted in September, oil production dipped by only about 535,000 barrels a day compared with 2015 despite “a wave of bankruptcies” in the space. And furthermore, Goldman Sachs estimated at the time that firms would ratchet up production by year-end to bring overall output up year-over-year — and that was before this massive spike in prices driven by OPEC cuts.
Long story short is that the global oil supply remains massive, and even if OPEC tries to eat into the overhang with a modest cut, the U.S. is still pumping like mad.
That would be bad enough for supply-and-demand dynamics if we weren’t also in an era of weakening oil demand. According to the IEA, global oil-demand growth peaked at a five-year high of 1.8 million extra barrels a day in 2015 but has steadily slumped to a growth rate of just 1.2 million barrels a day in global demand for 2016.
A host of factors are keeping back oil consumption, from a focus on cleaner energy sources and electric cars to anemic industrial output around the world. And the general outlook is pretty grim going forward, too.
If these trends continue, we may see global oil demand flat-line or even decline even as overall global production continues to grow despite the OPEC deal.
That doesn’t bode well for the long-term hopes of oil.
Big Oil is less equipped for this market
Given all this as context, it’s no wonder small-cap drillers have run up even as majors like Chevron and Exxon Mobil have struggled.
These smaller companies are more agile, and have been able to cut back on costs reasonably quickly over the last two years. Conversely, they also will be much quicker in scaling up to respond to more favorable pricing.
Exxon, on the other hand, is a $ 360 billion behemoth that is naturally less responsive to short-term market conditions. Remember, this is a company that partnered with a Russian state-owned oil company in an expensive long-term drilling project in the icy waters north of Siberia, which includes $ 3.2 billion in exploration costs alone.
If oil ever gets back to $ 80 a barrel or higher, that project may turn out to be a smart one … but if it drops back under $ 40 a barrel for an extended period of time, there’s no way Exxon is breaking even on production there.
And sure, Exxon announced earlier this year it would be cutting capital expenditures by a quarter year-over-year, but it’s still on track to spend about $ 23 billion this year on developing new oil fields. That’s in large part because it needs to show shareholders constant growth, but also because it needs a continual flow of oil sales to support its massive operations.
After all, Exxon has $ 46 billion in total debt — and in fact lost its coveted AAA credit rating this year as the depth of its troubles in the era of cheap oil were revealed.
On top of that, Big Oil valuations are already stretched with Exxon stock trading at almost 21 times next year’s earnings and Chevron trading at roughly 25 times forecast earnings!
To be clear, I don’t believe that Big Oil is going bust anytime soon. However, it’s highly unlikely that we’ll see significant improvement in the share price of majors like Exxon or Chevron in 2017 even if oil prices stick at $ 50 a barrel or higher.
That’s because they simply aren’t built for an era of stagnant demand and comparatively low prices, while smaller players in the space can move quickly as conditions warrant.
To be clear, that doesn’t necessarily make the small-cap explorers a sure thing. If and when oil prices roll back, they will suffer a lot more than shares of Chevron or Exxon. But at least in times like this, swing traders can find opportunity and strike while the iron’s hot.
As for Big Oil, the story remains the same: a challenging long-term outlook, and little chance of outperformance.
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