On Monday, oil futures prices were crushed – falling over $5 a barrel from the rarified $70s to the disappointing $60s. Not surprisingly, energy stocks were slammed, along with the overall market.
Investors were upset by the surge in Covid-19 cases around the world and that the economic recovery is at risk, with its knock-on effect on global oil demand. This fear emerged at the exact same time OPEC+ announced an agreement to add more oil to the market, including upping the United Arab Emirates’ supply share.
How could a 7.5% oil price collapse be good? It’s good when it washes speculation out of the market, sets a supply outlook for the next 18 months, and reinforces the good work the industry has been doing to improve its financial performance. Traders buying oil futures contracts had doubled oil prices over the past six months. At a 6.5-1 ratio of long (higher expected prices) versus short (lower) contracts heading into Monday, oil prices were ripe for a correction. Boy, did we get that! We just blew the foam off the glass of beer.
For commodity and stock markets, though, a little fear is always a good thing.
What the OPEC+ agreement did was provide a road map for future oil supply growth. OPEC+ will add 400,000 bpd to the market each month through the end of 2022. At that point, all the oil removed from the market following the collapse of oil demand in early 2020 will have been added back. This additional supply will not prevent the oil market from tightening further, but with a little help from U.S. shale producers and other producers around the world, we should avoid the punishing economic effects of $100 oil, although $80-$85 by the end of the year may still be realized. Such a defined environment allows producers to plan more drilling and production activity, just what the service industry needs.
The industry has done a good job preparing for this environment. It has pushed for drilling permit approvals, despite the Biden administration’s efforts to shut down domestic oil and gas. With 2,500 new permits in hand in the first half of 2021, estimates are companies may secure 6,000 permits total this year. When coupled with more than 5,000 drilled-but-uncompleted wells, this positions the industry to grow output this year and next. Importantly, the growth can be achieved while companies continue exercising financial discipline, exactly what investors are demanding.
E&P companies are now generating positive free cash flow from operations, which provides more funds to return to shareholders. Rather than counting on investors clamoring for growing output, share prices can rise on strengthened balance sheets and increased investor returns. Given this outlook, energy should continue to outperform the overall stock market, reversing its performance of the past decade. What a welcomed change that would be.
