Richard Pzena's Q4 Letter: The Normal Price of OilVW Staff
Richard Pzena of Pzena Investment Management discusses oil prices investing in exploration and production companies in his fourth quarter 2014 commentary.
The markets are in the early stages of correcting for an oversupply of oil. There will be winners and losers, with the longterm oil price dictated by the economics of supply.
The price of oil has been cut in half in the last six months, sending shock waves through the industry and slicing equity valuations across the energy sector. Investors are at a crossroads, with the big question being whether this is a buying opportunity or if caution is warranted. We view recent developments as the inevitable beginning of a classic market adjustment to a supply/demand imbalance, and believe we are in the early stages of the cycle as energy companies around the world struggle with the impact of lower oil prices. While this rebalancing will take time, we don’t expect the current cycle to be as long as the oil slump of the 1990s. Thus, it is imperative to focus now on the likely winners and losers, paying particular attention to businesses that have operational and financial flexibility to withstand additional volatility and that can adapt to the new realities.
Richard Pzena: Supply Drives Price
In the near term, the price of oil can swing wildly from small changes in supply and demand, with no natural bottom or top that is easily ascertainable. That is why over the past thirty years there have been only two periods during which the price of oil has not moved by more than 40% over a two-year period.
Over the long-term, changes in supply tend to have much larger swings than changes in demand. Most investors, however, spend their time focused on short-term moves while losing sight of the true driver of long-term oil prices – the economics of supply.
Over the long-term, oil prices revert to the level at which new projects needed to satisfy marginal demand earn an adequate return on investment. Not even OPEC has the ability to keep prices above or below the market’s natural clearing price indefinitely. After a long stretch of low oil prices and underinvestment in the 1990s, prices rose dramatically, providing oil companies with the cash flow needed to help supply catch up with global demand. We view the recent oil price slump as a clear sign that prices stayed too high for too long, leading to the current oversupply of oil. The resulting price correction is the market’s process of reducing the level of capital investment such that supply better matches demand.
We believe it will be the persistence of low oil prices and a sharp reduction in industry cash flow that produce the cuts in capital spending necessary to bring the markets back into equilibrium. Although in the context of the nearly 100 million barrels of oil consumed per day the magnitude the oversupply of about 3 million barrels is quite small (compared to an oversupply of 10 million barrels per day and 60 million barrels of demand in the 1980’s), we believe it will still take a few years for the market to fully adjust. Behavior changes slowly as companies take time to internalize and reflect lower long-term oil prices in their forecasts. Oil price hedges, long-dated offshore projects for which capital spending is largely immutable, and simple oil price optimism are all likely to contribute to a slower decline in supply growth than most anticipate.
Richard Pzena: The Normal Price of Oil
To estimate the long-term price of oil, our main focus is on the industry’s marginal sources of non-OPEC supply – U.S. shale, Canadian tar sands, and offshore deepwater wells, noting that 84% of 2014 global oil supply growth came from U.S. shale. Each source has projects with a wide range of underlying costs; however we estimate that, on average, these supply sources require $80 per barrel, $100+ per barrel, and $80 per barrel, respectively, in order to earn an adequate return based on today’s industry cost structure.
We also know from history that costs are sensitive to changes in the commodity price (Figure 1). As the industry adapts, companies make adjustments and are able to earn acceptable returns on new projects at lower oil prices. Should input costs drop by as much as 25% from current levels, a long-run oil price of $60 per barrel would still allow marginal suppliers to earn their cost of capital.
Clearly, $100 per barrel was too high of a price to remain in equilibrium – there was simply too much supply created. As the costs begin to fall with reduced activity levels and lower prices, the economic incentive to drill will require lower prices than historically. In addition, the long-term trend in the price of oil indicates the normal price today should be approximately $70 per barrel (Figure 2). Thus, we continue to believe that the long-term range of oil prices should be somewhere between $60 and $80 per barrel.
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