BORR - OIH: The OPEC Cuts Bolster The Case For Oilfield Services

2023-04-04 11:58:17 ET

Summary

• OPEC shocked the markets on Sunday with its surprise announcement of 1.16 million barrels per day production cuts plus another 500,000 barrels from Russia.
• The motivation isn't fully clear but one explanation is that OPEC wants a more stable price environment that incentivizes new investment.
• I discuss why this is bullish for oilfield services and particularly for the offshore sector.

OPEC burns the shorts

Going into the weekend prior to the Joint Ministerial Monitoring Committee (JMMC) meeting, market participants were expecting OPEC to stick to its production quotas from October, when 2 million bbl/d were cut. Futures positioning among large speculators was apparently the least long in 12 years:

Then on Sunday, OPEC+ surprised everyone with voluntary production cuts of 1.66 million bbl/d. OPEC members are contributing 1.16 million and Russia another 500 thousand bbl/d by rolling forward its own cuts announced earlier:

On Monday oil prices ( CL1:COM ) posted their biggest gain in a year:

According to OPEC's official press release from Monday:

The meeting noted that this is a precautionary measure aimed at supporting the stability of the oil market.

Overall, the price gains appear consistent with economists' view that a 1% supply shock translates into a 5% price increase.

Why cut now?

A lot has been said in the past two days by energy market observers:

• As recessionary concerns rise, OPEC is seeing more demand weakness ahead and moving pre-emptively to balance the market;
• The Saudis were displeased with the disconnect between physical and futures markets and wanted to short-circuit excessive speculation;
• OPEC's is displeased with the Biden administration for reneging on promises to refill the SPR;
• OPEC is siding geopolitically with Russia and China and seeking to pressure the West through energy inflation;
• OPEC needs higher prices to finance government expenditures.

Ultimately, we may never know the true motivation. What seems more certain, though, is that OPEC made this move simply because it could. A few years ago, a voluntarily supply curtailment would have been compensated by increased U.S. shale production. OPEC's cuts suggest that this time around the cartel isn't worried about losing market share as shale may have already peaked. Shale's decline is now even making headlines at the Wall Street Journal.

Second, OPEC restores some of its spare capacity as a number of members were underproducing their quotas :

With more spare capacity, OPEC will have more leverage to influence the market.

Finally, one could also argue that in the long term OPEC is doing the West a favor by maintaining a minimum price floor that incentivizes investment into new production. Capex remains low compared to historical levels, especially in real terms:

If OPEC doesn't react to prices in the $60s, investment will be reduced even further and may lead to very high prices in the medium term which in turn can crush economic development. OPEC itself has been announcing long-term investment plans to maintain or expand its production capacity, such as Aramco's goal to increase its capacity by 1 million bbl/d by 2027.

Implications for energy investors

While the geopolitical motivations, if any, remain unclear, there a few important takeaways:

• Contrary to the EIA forecasts , OPEC doesn't believe that U.S. shale can ramp up production;
• OPEC appears to be looking for a not too high, but stable oil price that incentivizes investment in production;
• OPEC itself is investing in its own productive capacity.

As I have argued before , these trends will be bullish for oilfield services companies, which have been lagging behind the broader energy sector ( XLE ):

One ETF that tracks the oilfield services sector is the VanEck Oil Services ETF ( OIH ), which responded sharply to the OPEC announcement:

The diminished role of U.S. shale also opens up many long-cycle projects, particularly offshore, that wouldn't have been approved a few years ago. The reduced capacity of the services industry, combined with the renewed interest in these projects, perhaps explains the recent outperformance of offshore service companies such as Borr Drilling ( BORR ), Transocean ( RIG ) or Tidewater ( TDW ):

I'm also bullish on onshore services providers, especially after the recent sell-off. If shale is on the decline as OPEC seems to think, there will be greater demand for services to maintain production levels. However, onshore providers with exposure to natural gas ( NG1:COM ) may be at risk in the short term:

Natural gas futures actually fell after the announcement:

Oil in the $60s may have limited oil drilling and by implication associated gas, which has become a significant factor with rising gas oil ratios in U.S. shale. However, after OPEC's move, oil-focused shale companies are more likely to maintain production which could be bearish for natural gas, at least in the near term.

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