REPX - OPEC+ Production Cut: A Massive Gift To The Oil Sector

2023-04-05 00:18:19 ET

Summary

• OPEC+ decided to cut oil production starting in May by 1.16 million barrels per day.
• This cut should last through the rest of the year and it seems to solve the disparity that existed between OPEC and the EIA.
• The move higher is warranted, and investors now have plenty of interesting opportunities to consider.
• The smallest firms moved up the most in response to the news, which indicates an appetite for risk.

Investors were taken by surprise on April 2 ^nd when news broke that OPEC+, the group of nations that comprises a sizable percentage of the oil production on the planet, announced unexpected cuts in output. This move came even in spite of a previously rosy forecast for the supply and demand balance that OPEC made public in their monthly report for the month of March. In response to this move, oil prices surged higher on April 3rd, taking the shares of many oil and gas exploration and production companies up as well. While I was also surprised by this move, this does solidify my own view on what the likely direction for oil prices will be in the near term. It also clears up a rather interesting disparity in data that I pointed out last month. In all, investors would be wise to see this as a bullish development for any company that benefits from higher oil prices. But in particular, the exploration and production companies could be very appealing to consider at this time.

A big surprise

In an article that I had published on March 23rd, I made the claim that oil prices were likely to rise moving forward. This came even as crude prices were only beginning to recover following a plunge that occurred because of banking crisis fears. In looking at the data, I pointed out that the direction that oil looked likely to take ultimately depended on whose data you believed. In that article, I looked at data provided by two different groups. The first of these was the EIA (Energy Information Administration). And the second was OPEC itself.

My goal in writing this article is to not focus too much on what I wrote in that prior article. In general, I would recommend you read it as well. But it should be said that there was a tremendous difference of opinion in terms of what the future held. According to the EIA, for instance, it was estimated that supply would outpace demand this year by roughly 0.57 million barrels per day. Unfortunately, OPEC does not provide guidance as to what its own output will be for an extended period of time. But using the output that the group had enjoyed in the most recent quarter, I estimated that we would go from having a surplus of crude oil of 0.11 million barrels per day in the first quarter of this year to having a deficit of 1.18 million barrels per day. Based on the data, this would imply a total amount of demand in excess of supply of 126.6 million barrels for the 2023 fiscal year.

After looking at this split opinion, I decided to entertain two different scenarios. The first scenario was if OPEC would be correct in its assessment. In this case, you could expect oil prices to remain elevated, including to even rise from where they have been. And the other scenario where the EIA turned out to be accurate, I concluded the prices would still likely rise, or at least stay where they are, because there was good reason to believe that, unlike a few years ago, OPEC would actually cut production further. Again, I refer you to the aforementioned article. But in short, the absence of a surge in oil production from the US and a substantial decline in drilled but uncompleted wells, means that US shale output is not the threat that it was years ago. Because of this, OPEC could go on to cut production without having its market share eaten away.

It appears that, whether because of a shift of opinion, or the decision to proceed with caution, OPEC+ has elected to be aggressive in getting higher prices. As is usually the case, the greatest amount of the cut from the group will come from Saudi Arabia and Russia. They will be responsible for a cut of about 500,000 barrels of crude per day, each, with Iraq coming in behind that at 211,000 barrels per day. That will leave the UAE in 3rd place with a reduction of 144,000 barrels per day. The production cuts will begin in the month of May and are slated to continue through the end of this year.

For my Marketplace service, Crude Value Insights, I regularly track an index that I made that covers 36 companies that are largely focused on oil and gas exploration and production activities. Some of them have midstream operations or other operations under their umbrella. But their primary emphasis is on the actual exploration and production side of the business. In response to the move to cut output, Brent crude prices spiked 6.7%, climbing to $84.93 per barrel. WTI crude, meanwhile, jumped 7.1% to $80.42 per barrel. By comparison, the CVI Oil & Gas E&P Index as I call it reported upside of nearly 8.4% for the day, with a median return of 6.4%.

Almost all of the companies in the Index reported upside for the day. At the very top of the list was Riley Exploration Permian ( REPX ). Shares of it rose 11.9%. This makes sense when you dig into the numbers. Last December, I performed a cash flow deep dive into the company. At that time, WTI crude prices of $70 per barrel and natural gas prices of $6 per Mcf, would have translated to EBITDA of $177 million and operating cash flow of $172 million. Using current prices, with oil at $80.75 per barrel and natural gas at only $2.12 per Mcf, these numbers would be $194 million and $189 million, respectively. With 88% of its production activities involving crude oil and NGLs, it's not surprising that the company would perform so well in response to this development.

It's not the only winner of the group. Also rising 11.9% for the day was Ovintiv ( OVV ). Only 51.2% of its output involves oil and NGLs. But it was likely aided by an announcement on the same day that it was acquiring some rather significant assets in the Midland Basin in a deal initially valued at $4.275 billion. $3.125 billion of this would be in the form of cash, with 32.6 million shares being issued for the remaining $825 million. Though with the increase in share price, the owners of these assets are now receiving an extra $140.2 million if the stock price doesn't retreat. No doubt, some of the positive reaction here stems from the fact that this transaction would increase the company's exposure to oil in the Permian from 55% of output to 65%. To cover some of this cost, Ovintiv has decided to sell off some of the assets that it has in the Bakken in exchange for $825 million.

The rest of the top five best performers we're definitely oil-heavy. One of these, the troubled Abraxas Petroleum (AXAS) saw an 11.1% rise in share price. That's not surprising when 67.1% of its production includes oil and NGLs. Slightly above that was Vital Energy ( VTLE ), with 72.7% exposure to these commodities pushing the stock up at 11.4%. And finally, we had Callon Petroleum ( CPE ), which appreciated by 10.6% thanks to the 81.8% exposure that it has to oil and NGLs.

As you can see in the chart below, there does seem to be something of a trend between the size of the companies at the beginning of the close of business the day prior and how much shares appreciated. The smallest of the firms tended to do, on average, far better. This makes sense when you consider that prior pricing movement was indicative of the market seeking safety and stability in the larger players in the space. What this suggests is that investors wanting to play this move higher, with the possibility of $100 per barrel oil or more, should consider some of the smaller players. Though I would definitely prioritize those firms that have lower amounts of leverage just to be safe.

Though not included in my Index, I should not leave out a couple of the major oil and gas companies like Exxon Mobil ( XOM ) and Chevron ( CVX ). Because of their large and diverse nature, I have kept them out of the Index. But they undoubtedly will benefit as well. Shares of Exxon Mobil shot up 5.9% for the day, while Chevron rose a more modest but still impressive 4.2%. According to the management team at Exxon Mobil , a $1 swing in realized crude prices for the company would impact after-tax profits for its Upstream segment by $500 million per annum. A movement of $0.10 per Mcf, meanwhile, will impact earnings under this segment for better or worse in the amount of $140 million. By comparison, a $1 change in pricing for Brent crude should affect after-tax earnings for the company of roughly $400 million, while a change of $0.10 per Mcf for natural gas prices would change after-tax earnings by $42.5 million. Ignoring any possible change in natural gas prices, this means that the move higher for Exxon Mobil was driven by the expectation that earnings should be around $2.7 billion higher, while for Chevron that number should be just over $2 billion.

Takeaway

Right now, the market seems to be incredibly excited about this development. I, like so many others, was taken by surprise. However, this seems to solidify the views I laid out in my aforementioned prior article on the company. The firms that benefited the most from this change are those that are smallest. But because of the changing market conditions, there likely is some attractive potential even amongst the larger players in the space. Those who want incredibly large and stable companies might want to consider diversified players like Exxon Mobil or Chevron. But for those who are focused more on upside, irrespective of the risk, the smaller prospects in the space, such as some of those that I laid out above, might be the best way to go.

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