JJE - 'Watch Out!' Saudis Make Good On Supply Cut Threat But The Market Is Betting Against OPEC

2023-06-06 17:32:43 ET

Summary

• Over the weekend, Saudi Arabia announced voluntary cuts of 1 million barrels per day for a month in an attempt to raise oil prices.
• This comes after previous OPEC+ cuts in March.
• US oil consumption is declining due to factors such as increased energy efficiency, work-from-home, and electric vehicle adoption. This is causing uncertainty in the oil market.
• The outlook for oil stocks depends on competing narratives of oil demand growth and supply, including the impact of renewable energy investments.
• The two wildcards for the oil market are China and whether the US economy enters a recession.

I don’t have to show my cards, I’m not a poker player … but I would just tell them, watch out.”

-Saudi Oil Minister, Prince Abdulaziz bin Salman

OPEC+ members gathered over the weekend in Vienna, Austria. There, the cartel agreed to stick to previous 2023 production targets, but Saudi Arabia announced voluntary cuts of 1 million barrels per day for a month, with an option to extend. This comes on top of rounds of previous cuts. Saudi Arabia shocked the markets in March by leading a 1.2 million barrel per day production cut, but the effect on oil prices was short lived, with recession fears continuing to eat into the price of oil in the futures market.

Last year, the Saudis seemed to have the market nailed. After the 2022 Russian invasion of Ukraine, WTI oil prices rocketed to more than $120 and Saudi Arabia refused the Biden administration's requests to boost production. Since then, supply has come out of the woodwork while demand has been sluggish, and traders have become increasingly concerned about the US economy and implications for oil demand.

Saudi Arabia Doubles Down On Supply Cuts

The Saudis continued their long-running feud with the Biden administration with this weekend's voluntary decision to cut another 1 million barrels per day from oil production. In a vacuum, this would be expected to increase oil prices. But the market has other ideas. Since Silicon Valley Bank ( OTCPK:SIVBQ ) collapsed in early March, oil prices have tanked as traders bet on a US recession, and futures haven't really recovered.

OPEC has sought to force the market to price things differently. Saudi Oil Minister Prince Abdulaziz bin Salman recently warned speculators to "watch out" after futures markets began to price large declines in oil. With a mostly empty Strategic Petroleum Reserve, it seems like it would have been the perfect time for the Saudis to raise the stakes. To my surprise, the market has barely flinched. That's largely because the US economy really hasn't been demanding as much oil as was expected. The US consumes about 20% of the world's oil, but we haven't been as thirsty lately as we were 20 years ago, or even as much as we were pre-pandemic.

There are many reasons for this , such as cars becoming more efficient, electric vehicle adoption, and improved energy efficiency in buildings. What hasn't driven this decline is Americans driving less, which would happen in a big way if a recession got underway (and did happen post-2008). For this reason, the US economy is a huge wildcard for the oil market.

This has been echoed by huge drops in oil demand in Europe. On the supply side, Russia is quietly exporting as much oil as ever. Still, the IEA projects global oil demand to hit a record of nearly 102 billion barrels per day in 2023 against flattish supply, tipping the market into a shortage. If this comes to fruition, the Saudis are likely to reap big profits from their supply cuts and see oil surge higher yet again. If oil demand instead falls, then the US and the EU's energy transition plans are working ahead of schedule. It's hard to reconcile these forecasts with the trading in the oil markets, so what gives?

What About China?

Another wildcard here for oil is China. The trouble with China is that it's hard to know exactly what's going on there. The Chinese government isn't exactly keen to publish how much oil they're importing, so it has to be estimated. So far, estimates show that China is expected to set a record high for oil consumption in 2023. If this is true, we can probably take the IEA's estimates for global supply and demand for oil in 2023 at face value.

These estimates and the IEA monthly reports point toward a rather large oil shortfall in the second half of the year. If so, the Saudis have laid a clever trap by cutting production and are about to profit big. But behind the scenes, China is going all-in on energy efficiency and electric vehicles, with EV adoption outpacing the US . China produces little oil itself and has every incentive to cut oil imports as quickly as possible.

What will happen going forward? If oil supply and demand behave according to recent forecasts, the Saudis are likely to score a big win. In this case, oil would push back toward $100 per barrel. However, if the bears are right and oil consumption in the US and EU continues to fall while China remains sluggish, then the Saudis would have given away market share, taking years to be profitably regained. Despite lower prices, Biden is still holding out on refilling the SPR – whether his gamble will pay remains to be seen.

Oil Stocks: Buy Or Sell?

In the oil markets, it pays to be a contrarian. In 2020, I wrote that oil demand would likely bounce back and that buying Exxon Mobil ( XOM ) would be like buying banks in 2009 . Everyone hated oil stocks. Then, the stock yielded about 8% and was briefly valued at less than Zoom ( ZM ), the video chat company. Now, the tables have turned, and investors have learned to love oil stocks again. Oil demand is incredibly stubborn historically, and those who sell oil stocks when the economy is down tend to sell far too cheaply. I think it was fairly obvious in 2020 that oil demand would bounce back strongly. However, I wouldn't bet on this as much going forward.

There have been two big changes since 2020.

1. Russia invaded Ukraine and oil prices surged, which led to large-scale efforts in Europe and the US to reduce energy demand.
2. The US passed the "Inflation Reduction Act (IRA)," spurring supply via huge renewable energy investments. Similar laws were passed in Europe and Australia. These two factors worked in concert to hold down demand and increase the supply of energy.

Oil stocks look cheap on a PE basis, but their earnings estimates are always a crapshoot. Exxon appears to trade at a 10.5x PE, Chevron ( CVX ) at 11x, ConocoPhillips ( COP ) at 10.5x, and Occidental Petroleum ( OXY ) at 12x.

At first glance, these look really cheap, and Buffett seems to agree by buying more shares in OXY every time it trades below $60. Buffett has a special deal with OXY due to having warrants and convertible debt as well as common stock . However, oil stocks are often cheap when they're "expensive" and expensive when they're "cheap." Keep in mind that they're going against brutal comps from 2022 when many oil companies reaped windfall levels of profit. To some extent, the oil futures market disagrees with the market for oil stocks, with the latter signaling more optimism than the former. Oil is far from dead, but the multiples that oil stocks are changing hands for do give me pause with the economic cycle turning.

Bottom Line

Whether oil stocks make good investments over the next few years comes down in large part to competing narratives. Will oil demand grow and supply stay sluggish as projected? Or have investments in renewables and efficiency in the US, Europe, and China paid off in the form of permanently reduced demand? One thing is likely sure – if the unemployment rate in the US rises by more than a percentage point or so, then oil stocks are likely to take a beating. I don't have a strong opinion on whether the Saudis or the Biden administration is right about the oil market but now seems like a good time to take some profits if you expect the economy to weaken. If you expect the economy to hold steady, then oil stocks are attractively priced What do you think? Feel free to offer your thoughts in the comments!

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