The past two years have been brutally tough on the oil industry. Persistently weak oil prices and increasing uncertainty caused approximately 100 oil and gas producers to declare bankruptcy since the onset of the downturn. Meanwhile, most other producers cut costs to be bare bones, causing their output to drop.
However, prices seemed to bottom out in early 2016 Opens a New Window. and should be much more stable in 2017 Opens a New Window. as a result of two OPEC agreements to rebalance the market. That intervention, combined with falling costs and efficiency gains, means 2017 could be one of the best years to invest in oil stocks in quite some time.
Draining the stockpiles
At the end of November, OPEC members agreed to end their battle for market share and instead refocus their attention on supporting oil prices by agreeing to cut their combined output by 1.2 million barrels per day. A couple of weeks later, OPEC announced an agreement with 11 non-member nations who pledged to join it by reducing their production by 558,000 barrels per day for the next six months. The aim of these reductions is to start eliminating the glut of oil that has built up over the past two years due to persistent oversupply. If everything goes according to plan, these actions could drain 46% of the estimated 300 million barrel excess stockpile over the next six months. That would result in a more balanced oil market going forward, which could stabilize oil prices much higher.
While many market watchers have their doubts that OPEC will implement these agreements to the full extent, even partial compliance should help reduce the supply overhang quicker than relying on the natural decline of production due to underinvestment. That said, after two years of underinvestment, the market has gotten much closer to rebalancing on its own. According to data from oil-field service company Core Labs (NYSE: CLB), production in the U.S. has already fallen by 1.3 million barrels per day since peaking in March 2015. That decline, when combined with similar natural declines elsewhere, has global production on pace to slump 3.3% in 2016. Meanwhile, demand continues to march higher, which should lead to a much tighter oil market in 2017 even without OPEC. In fact, that outlook had Core Labs anticipating that a V-shaped recovery in the oil market was on the horizon well before OPEC stepped in to support prices.
Unless oil demand falls off a cliff, market fundamentals should be much better in 2017 than they were for most of the past year. This improvement alone should lift a weight that had been holding down oil stocks.
Repositioned and ready to grow
Before the downturn; many oil companies relied on triple-digit oil prices to fuel their businesses. However, with those prices a distant memory, producers worked hard to get their costs down to run at much lower prices. Those efforts are about to pay off, with many oil companies recently announcing that they have reached a turning point in their repositioning efforts, and are now in the position to thrive at lower prices.This transformation has been nothing short of remarkable and is a major catalyst for oil stocks in 2017.
Leading U.S. independent oil company ConocoPhillips (NYSE: COP), for example, has reduced its breakeven point from more than $75 per barrel to less than $50 per barrel in just the past couple of years. The company had to make several tough decisions to get to that level, including slashing the dividend and exitingits deepwater exploration program. However, ConocoPhillips can flourish at $50 oil going forward because it can generate enough cash flow to grow the dividend, pay down debt, buy back stock, and boost output by up to 2% per year. Meanwhile, ConocoPhillips has built in tremendous flexibility into its operations so that as oil prices go up, so does the company’s ability to grow production and increase shareholder distributions.
Shale-focused producers, likewise, have experienced a dramatic transformation over the past few years. For example, Devon Energy (NYSE: DVN) and Concho Resources (NYSE: CXO) both stopped growing in 2016 to focus their attention on reducing costs by capturing drilling efficiencies, optimizing well completions, and high grading their portfolios. Those efforts are ready to bear fruit, which has both companies positioned to start growing again in 2017 at much lower prices. Concho Resources, for example, can now increase its oil production by a 20% compound annual growth rate through 2019 while living within projected cash flows at current oil prices. Meanwhile, if oil prices rise, Concho Resources has an abundance of high-return drilling locations to capture those higher prices.
Devon Energy, meanwhile, believes its cash flow will more than double in 2017 to $2.5 billion if oil and gas average $55 and $3, respectively. That is enough cash flow to enable Devon to deliver double-digit U.S. oil production growth next year. Meanwhile, at $60 oil and $3.25 gas, Devon’s cash flow could jump 200% to roughly $3.5 billion, which would enable the company to grow even faster.
Thanks to falling supplies, the oil market could quickly rebalance in 2017, which should stabilize prices, if not push them much higher. Meanwhile, dramatic cost reductions have oil producers positioned to grow at much lower prices going forward. Because of this combination, 2017 could be an excellent year for oil stocks.
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